The Payback Method
Read this section on the Payback Method of investing and review the examples of how this method is used.
Disadvantages of the Payback Method
Payback period analysis ignores the time value of money and the value of cash flows in future periods.
LEARNING OBJECTIVE

Explain the disadvantages of the Payback Method
KEY POINTS
 Payback ignores the time value of money.
 Payback ignores cash flows beyond the payback period, thereby ignoring the "profitability" of a project.
 To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.
TERMS
 return
Gain or loss from an investment.
 Opportunity cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
 cost of capital
the rate of return that capital could be expected to earn in an alternative investment of equivalent risk
Disadvantages of the Payback Method
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk,financing, or other important considerations, such as the opportunity cost. While the time value of money can be rectified by applying a weighted average cost of capitaldiscount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are netpresent value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.
Zhuhai sea front development: Payback is the amount of time it takes to return an initial investment; however, it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
Payback ignores the time value of money. For example, two projects are viewed as equally attractive if they have the same payback regardless of when the payback occurs. If both project require an initial investment of $300,000, but Project 1 has a payback of one year and Project two of three years, the projects are viewed equally, although Project 1 is more valuable because additional interest could be earned on the funds in year two and three.
Payback also ignores the cash flows beyond the payback period, thereby ignoring the profitability of the project. Thus, one project may be more valuable than another based on future cash flows, but the payback method does not capture this.
Additional complexity arises when the cash flow changes sign several times (i.e., it contains outflows in the midst or at the end of the project lifetime). The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback period is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.