This technique estimates the time required by the project to recover, through cash inflows, the firm’s initial outlay. Beginning with the project with the shortest payout period, different projects are arranged in order of time required to recapture their respective estimated initial outlays. The payback period for each investment proposal is compared with the maximum period acceptable to management and proposals are then ranked and selected in order of those having minimum payout period.
While estimating net cash inflows for each investment proposal, the following considerations should be borne in mind:
(i) Cash inflows should be estimated on an incremental basis so that only the difference between the cash inflow of the firm with and without the proposed investment project is considered.
(ii) Cash inflows for a project should be estimated on an after-tax basis.
(iii) Since non-cash expenses like depreciation do not involve any cash outflows, estimated cash inflows from a project should be adjusted for such items.
Accept the project if the payback period calculated for it is less than the maximum set by the management. Reject the project if it is otherwise. In the case of multiple projects, a project with a shorter payback period will be selected. In essence, the payback period shows a break-even point where cash inflows are equal to cash outflows. Any inflows beyond this period are surplus inflows.
Advantages of Payback Period Method:
1. It is easy to understand and calculate, thus, investment proposals can be ranked quickly.
2. For a firm experiencing a shortage of cash, the payback technique may be used with advantage to select investments involving minimum time to recapture the original investment.
3. The payback period method permits the firm to determine the length of time required to recapture through cash flows, the capital expenditure incurred on a given project and thus helps it to determine the degree of risk involved in each investment proposal.
4. This is ideal in deciding cash investment in a foreign country with a volatile dynamic political position where a long-term projection of political stability is difficult.
5. This is, likewise, more preferred in the case of industries where technological obsolescence comes within a short period; say electronic industries.
6. This method is a good indicator of liquidity. If an entrepreneur is interested to have greater liquidity for the firm, he can choose the proposal, which will provide early cash inflows.
Disadvantages of Payback Method:
1. The payback method ignores the time value of money and treats all cash flows at par.
2. The payback method does not consider cash flows and income that may be earned beyond the payout period so it is not good to measure profitability. It gives misleading results.
3. Moreover, it does not take into account the salvage or residual value, if any, of the long-term asset.
4. The payback technique ignores the cost of capital as the cut-off factor affecting the selection of investment proposals.
Suitability of using Payback Period of Method :
The payback period method may be successfully applied in the following circumstances:
(i) where the firms suffer from liquidity problem and are interested in the quick recovery of the fund than profitability;
(ii) the high external financing cost of the project;
(iii) for projects involving very uncertain return; and
(iv) political and economic pressures.
It may, therefore, be said that the payback period is defined as the measure of the project’s liquidity and capital recovery rather than its profitability