The payback method is a very popular investment appraisal technique. It is essentially an expression of the time taken to recover the initial cash outlay on investment from the investment’s cash flow returns. Generally, firms tend to set a fixed maximum payback period (PBP) for projects and use it for decision-making.
Thus, the decision rule using payback is: “If the actual payback period is less than the predetermined maximum period, the project is acceptable; if the actual payback period is greater than the maximum period allowed, the project is rejected.” However, there is no rational rule to say what the predetermined maximum period should be, and this varies from case to case. To calculate the payback period, the annual net cash inflows from a project are accumulated until they equal the project’s initial cash outlay. Net cash inflows can arise from an increase in income and/or savings in operating costs.
Payback has the following advantages:
- it is simple to use and easy to understand;
- takes the timing of cash inflows into account;
- and serves as a useful risk screening device.
The limitations of the payback method are:
- it does not take account of all cash flows;
- treats the timing of cash flows within the payback period in a very cursory way;
- does not measure profitability or returns;
- does not provide a rational decision-making rule;
- and ignores the time value of money by not discounting cash flows to find their present values.
Payback is frequently used to supplement more sophisticated investment appraisal techniques as a risk screening device.