Understanding Payback Period method
This method is also known as pay out, pay off or recoupment period method. Under this method, the original investment of the project should be received back out of the implementation of the project as early as possible. It means that the company gets additional earnings or savings if the project is implemented. Thus, it measures the period of time for the original cost of a project to be recovered from the additional earnings or savings of the project itself. When the total cash inflows from investments equals the total outlay, then the period is the pay back period of that project. Cash inflows should be calculated to find the pay back period. The term cash inflows refers to annual net earnings (profit) before depreciation but after taxes.
Accept or Reject Criteria of payback period
A project may be accepted or rejected on the basis of the per-determined (standard) pay back period if only one independent project is to be evaluated. The standard pay back period is determined by the management in terms of maximum period during which initial investment must be recovered.
A project is accepted if the actual pay back period is less than the standard pay back period. When two or more mutually exclusive projects are considered for selection, they may be ranked according to the duration of payback period. Thus, the project having the shortest pay back period may be assigned first rank, followed in that order so that the project with the longest pay back period would be assigned lowest rank.
How to calculate payback period? Formula for calculation:
Two information are required to calculate payback period. They are initial investment and annual cash inflows. The term initial investment refers to an amount used to implement the project or the cost of acquisition of fixed asset. The term cash inflows refers to annual net earnings (profits) before depreciation but after tax or annual savings made by purchasing new fixed asset or implementing new project.
The cash inflows may be even or uneven. If cash inflows even, the following formula is used.
Payback period = (Initial Investment or Original Cost of the Asset / Cash Inflows)
If cash inflows uneven, cumulative cash inflow statement is prepared and the following formula is used.
P = PYFR + ( BA / CIYER)
P = Payback period.
PYFR = Number of Years immediately proceeding year of Final Recovery BA = Balance Amount to be recovered
CIYFR = Cash inflow — Year of the Final Recovery
Merits or Advantages of Payback Period method
The chief merits of the payback period are briefly presented below.
1. It is very simple to understand and easy to calculate.
2. It requires less cost, time and labour when compared to other methods of capital budgeting.
3. This method reduces or avoids the loss through obsolescence since shorter payback period is preferred to longer payback period.
4. This method is mostly suitable to a company which has less amount of cash in hand and a company whose liquidity position is very weak.
5. It gives much importance to the speedy recovery of investment in capital assets.
Demerits / Limitations / disadvantages of Payback Period
The payback period method has some limitations. They are given below:
1. A slight change made in the labour cost or cost of maintenance, there is a much change in its earnings and affects the payback period.
2. This method ignores the short term solvency or liquidity of the business concern.
3. It ignores capital wastage and economic life by restricting consideration to the project’s gross earnings.
4. The time value of money is not considered in the payback period method.
5. It overlooks the cost of capital which is a main factor in sound capital budgeting decision. This method does not consider the cash inflows arising after the payback period.
6. This could be misleading in capital budgeting decisions.
7. This method fails to measure the productivity of capital expenditure plan because it does not attempt to measure the return on investment.
8. This method does not consider full earnings or full savings of the capital expenditure plan i.e. savings or earnings available during whole economic life of the project.
9. This method also fails to assign proper weightage to the unevenness of rate of profit of various projects.
10. It may be difficult to determine minimum acceptable payback period. Generally, it is a subjective decision.
11. This method treats the each asset individually in isolation with other assets. But, in practice, it is not feasible.
Suitability of Payback Period
1. This method is suitable to the units which is not having huge amounts in hand.
2. It is more suitable for the dynamic markets and under uncertain investment climate.
3. Now, there is fast moving economic world. Hence, every body prefers to recover the original investments as early as possible. In other words, everybody prefers the ventures which have shorter payback period.
4. This method is preferred by the companies which are suffering from liquidity crisis and want to get back their investment in short period of time.