Payback Period Method

Payback Period Method  is the simplest and most widely used method. Payback period is the time required to recover the initial investment. A firm is always interested in knowing the amount of time required to recover its investment.

It is based on the concept of cash flow and is a non-discounting technique.

Formula for Payback period

To apply this formula, we have to first calculate the cumulative cash inflows of each year.

Decision Criteria

  1. In case of competing projects, a project with a lower payback period should be selected.
  2. If there is only one project in consideration it would be selected only if it has a payback period as per managements expectation.

 

Merits of Payback Period Method

  1. It is easy to calculate and simple to understand.
  2. It is useful in case of those industries where there is a lot of uncertainty and instability because it lays emphasis on the speedy recovery of investment.
  3. Many firms want to recover their investment as quickly as possible. This method is more appropriate for them to know how quickly they could get their investments back.
  4. It shows liquidity of the investment.

Demerits of Payback period method

  1. Neglects cash flows occurring after the payback period: This method does not consider the amount of profit earned after the recovery of the cost of investment. Some projects may have higher cash inflows after the payback period.
  2. This method does not consider the time value of money.
  3. This method does not consider the risk associated with the project.

 

  1. Post Payback period:  The duration in excess of payback period till the economic life of a project.

              Post Payback period = Economic life – payback period

  1. Post Payback Profitability: The amount of profit, which a project could earn after the recovery of initial investment is called as payback profitability.

              Post Payback Profitability = Total Earning from project – Payback amount