• The payback period is the time it takes for a project's net cash inflows to equal the initial cash investment.
• The payback period is often used as an initial screening process.
• If a project's payback period is shorter than a defined maximum period then the project should be evaluated further using a more sophisticated project appraisal technique.
• A major disadvantage is that the timing of cash flows within the payback period are ignored and therefore no account is taken of the time value of money.

• A long payback means capital is tied up
• Focus on early payback can enhance liquidity
• Investment risk is increased if payback is longer
• Shorter-term forecasts are likely to be more reliable
• The calculation is quick and simple
• Payback is an easily understood concept

• It ignores the timing of cash flows within the payback period.
• It also ignores the cash flows after the end of the payback period and therefore the total project return.
• It ignores the time value of money (a concept incorporated into more sophisticated appraisal methods). This means that it does not take account of the fact that £1 today is worth more than £1 in one year's time. This is because an investor who has £1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate, say 10%, to get a return of £1.10 in a year's time.

• The method is unable to distinguish between projects with the same payback period.
• The choice of any cut-off payback period by an organization is arbitrary.
• It may lead to excessive investment in short-term projects.

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By Muhammad Atif Saeed on 13:01. Filed under Financial Management . Follow any responses to the RSS 2.0. Leave a response