What are the advantages and disadvantages of pay back period?

Answer 1

Advantages and Disadvantages of Payback PeriodPayback period is a capital budgeting concept which refers to period of time which is required for a project to generate a return on investment which will cover the original investment made by a company on the initial project cost. So for example if the initial project cost is $50000 and annual cash flow from such project is $10000 then it implies that payback project would be 5 years.

The advantage of using payback period is that its ease of use and anybody who is having limited financial knowledge can apply it. It is also beneficial for those companies who are recently established and want to know the time frame in which they would recover their original investment, therefore those companies which do not want to take risk and want quick return on their investments can select those projects which have low payback period and ignore those projects which require long gestation projects.

While disadvantage of payback period is that ignores an important concept which is time value of money and therefore may not present true picture when it comes to evaluating cash flows of a project. It also ignores cash flows beyond the payback period and therefore it does not take into account the complete return which a project can generate and therefore it may reject a project which in the long term may be beneficial for a company.

Answer 2

Payback Period

Advantages

Simple to compute

Provides some information on the risk of the investment

Provides a crude measure of liquidity

Disadvantages

No concrete decision criteria to indicate whether an investment increases the firm's value

Ignores cash flows beyond the payback period

Ignores the time value of money

Ignores the risk of future cash flows

Discounted Payback Period

Advantages

Considers the time value of money

Considers the riskiness of the project's cash flows (through the cost of capital)

Disadvantages

No concrete decision criteria that indicate whether the investment increases the firm's value

Requires an estimate of the cost of capital in order to calculate the payback

Ignores cash flows beyond the discounted payback period

Younes Aitouazdi: University of Houston Downtown