In this article, you’re going to know about Limitations of payback period method or disadvantages of payback period method.
What is the Payback Period Method?
The Playback period method refers to the time it takes to recover the cost of an investment. Simply put, the payback period is the period of time when the investment reaches the break-even point.
This payback period method is also call as payout, the payoff or recurrence period. Under this method, the original investment of the project should retrieve as soon as possible from the implementation of the project. This means that the company gets additional earnings or savings when the project is implemented. Thus, it charges the period of time for the original cost of the project, from the extra income or savings of the project. When the total cash flow from the investment is equal to the total outlay, that period is the period of that project. Calculation of cash inflows should be done to find back period. The term Cash Inflow refers to the annual net income (profit) before the depreciation but after taxes.
The Playback Period method of valuation of capital expenditure projects is very popular because it is easy to calculate and understand. However, there are serious limitations and ignores many important factors. That should consider when the economic viability of the projects evaluated.
8 Limitations Of Payback Period Method
Limitations of payback period method –
Neglect of time value of money:
The most serious disadvantage of the payback method is that it does not consider the value of money time. The cash flow has received during the initial years of a project gets more weight to compare to the cash flow received in later years. Two projects can have the same payback period. But one project generates more cash flow in the initial years. While the second project has more cash flows in later years. In this example, the payback method does not provide a clear definition of which project to choose.
Doesn’t consider returning the project on investment:
Some companies require capital investment to overcome a certain barrier of return rates. Otherwise, the project is rejected. The payback method does not consider the return rate of the project.
Neglected cash flows after the payback period:
For some projects, the largest cash flow can’t occur after the end of the payback period. Investment in these projects can be more profitable and may be better for projects that have less payback times.
Ignores the profitability of the project:
Just because a project has a short retreat period does not mean that it is profitable. If cashback expires in the payback period or falls too low, then a project can never return benefits and therefore, it would be an illogical investment.
The payback period method is simply that it does not consider normal business scenarios. Generally, capital investment is not a one-time investment. Rather such projects need more investment in the next years. In addition, projects usually have irregular cash flows. This is disadvantages of payback period method.
Limitations of payback period method – The project with a short payback period is not guaranteed that it will be profitable. What if the cash flow from the project stops during the payback period. Or becomes less after the payback period. In both cases, the project will become inseparable after the end of the payback period.
Neglect of project return on investment – Some companies require capital investment for earning a return that is more than a fixed rate. If not, the project has been terminated. However, the payback method ignores the return rate of the project.
Not all cash flow was covered
The payback period method considers the cash flow only as long as the initial investment not returned. It fails to consider the cash flows coming in later years. Such a limited view of cash flow can force you to ignore a project. That can generate attractive cash flow in subsequent years.
The payback period method of concessional is that it does not take into account the cash flows coming after the break-even. In addition, it only shows the time required to recover the initial cost of a project and there is some break-even analysis technique. For this reason, this method can fight with NPV and therefore may be wrong. Also, there is no way to determine how low the payback period should be for accepting the project. In academic studies, the use of this method not recommended for mutually exclusive projects.
Despite the loss, the payback period method still widely used by businesses. The method works well when evaluating projects with small projects and appropriately consistent cash flow. Also, it is a tool for small businesses, for which liquidity is more important than profitability.
Even large enterprises also use this method. However, due to its limitations in giving a complete analysis. Businesses often use the payback method as the initial screening tool in order to scrap projects that do not meet their payback criteria. And then more detailed analysis or Use Other Capital Budget Methods Current Value (NPV) Analysis or Internal Rate of Return on Remaining Projects (IRR).
Thus, Now You all know that disadvantages of payback period method or Limitations of payback period method.