The basic characteristic of investment is that a stream of future cash flows follows accuracy outlay for a specified period. A rational investor would try to recoup his initial outlay from the cash flows in the quickest time possible during the economic time of the project.
Payback period may be defined as the number of years required to recoup or recover the initial investment from the generated cash flows. Since different projects have varying pattern and timing of cash flows, the projects will have a different payback period.
- In case of independent projects, the calculated payback period should be compared with standard-set by the company. If the calculated payback period is less than standard payback period, the project will be accepted otherwise rejected. For example, the project ‘A’ payback period is 3.5 years against standard payback period set by the company is four years. It should be accepted.
- In case of mutually exclusive projects, calculated payback periods of alternatives compared and the project which has lowest payback period is accepted.
Uniform cash flows:
If the proposed projects cash inflows are uniform the following formula can be used to determine payback period.
Non-uniform cash flows:
The second method is used when a project’s cash flows are not uniform but varies from year to year. In such a situation, It is calculated by the process of cumulating cash flows till the time when cumulative cash flows become equal to the original investment outlay.
Merits of Payback Period:
- It is easy to compute, communicate and understand, so it has become a popular method of evaluation.
- This method is beneficial in evaluating those projects which involve uncertainty.
- This method makes it clear that no profit arises till the payback period is over. This helps the companies in deciding when they should start paying dividends.
- The management knows the length of the time for which funds are locked up.
- It is useful for ranking the projects which are equally desirable under the other methods of capital budgeting. The project with the shortest payback period gets priority in selection.
Demerits of Payback Period:
- The method ignores the returns generated by a project after its payback period, projects having long gestation period will never be taken up if this method is followed through they may yield high returns for a long period.
- The method doesn’t take into account the time value of money.
- Fastness of recovery of investment amounts covers emphasis on liquidity.
- Payback is not a profitability measure.