Feb 18, 2019 · Furthermore, the payback analysis fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another.
The Problems with Payback Period, Part 1. If you’ve ever participated on a project team considering the purchase of a major piece of equipment, you’ve almost certainly heard of “Payback Period” – the length of time projected to recoup an initial investment through cost savings, increase profits, etc.
- Ray Harkins
Payback Period = $100,000 / $20,000 = 5 years. In an actual scenario, a payback period model can become a bit complicated with the addition of on-going costs like periodic maintenance, changes in work-in-process inventory, utility costs, etc. But once all the inputs are organized into a model, the payback period calculation itself is ...
The problems with the payback period method as a means of analyzing and comparing potential investments extend beyond its problem with the time value of money. In fact, that problem can be corrected (but rarely is in practice) by using a method called the “Discounted Payback Period”, where the future expected cash flows are “discounted ...
- Ray Harkins
People also ask
What is the payback period for a project?
What are the limitations of the payback period?
What is the shortest payback period?
Why is payback period important?
The payback period (which tells the number of years needed to recover the amount of cash that was initially invested) has two limitations or drawbacks: The net incremental cash flows are usually not adjusted for the time value of money. This means that a net incremental cash inflow of $50,000 in ...
Sep 20, 2017 · For instance, if the initial capital used to start the project was $60000 and the revenue that the project is bringing in each year is $20000 then that means that the payback period of that project would be 3 years. The choice between two or more investments regarding which one to go with is usually the one with the shortest payback period.
May 22, 2020 · The payback period for the project A is four years, while for project B is three years. In this case, project B has the shortest payback period. Advantages of payback period make it a popular choice among the managers. But like any other method, the disadvantages of payback period prevent managers from basing their decision solely on this method.
Payback Period Is Not Realistic as the Only Measurement. There is some usefulness to this method, especially in quick-moving industries with a lot of rapid change. The problem for most businesses is that they need to have a better balance of projects and investments so that their short, mid, and long-term needs are all taken care of.
- Decision Rule
- Advantages and Disadvantages
The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven.If the cash inflows are even (such as for investments in annuities), the formula to calculate payback period is:When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:Where,A is the last period number with a negative cumulative cash flow;B is the absolute value (i.e. value witho...
Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years. Calculate the payback period of the project.
The longer the payback period of a project, the higher the risk. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management.Manage...
Advantages of payback period are: 1. Payback period is very simple to calculate. 2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. 3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.Disadvantages of payback period are: 1. Payback period does not take into account...