Payback Period Method is popularly known as pay off, pay-out, recoupment period method also. It gives the number of years in which the total investment in a particular capital expenditure pays back itself.
This method is based on the principle that every capital expenditure pays itself back over a number of years. It means that it generates income within a certain period. When the total earnings (or net cash-inflow) from investment equals the total outlay, that period is the payback period of the capital investment.
Advantages of Payback Method
The payback period method for choosing among alternative projects is very popular among corporate managers and according to Quirin even among Soviet planners who call it as the recoupment period method. In U.S.A. and U.K, this method is widely adopted to discuss the profitability of foreign investment.
However, its popularity has also brought with it serious scrutiny and criticism of its shortcomings, but it has its certain advantages that are follows:
(1) It is easy to understand, compute and communicate to others. Its quick computation makes it a favorite among executives who prefer snap answers.
(2) It gives importance to the speedy recovery of investment in capital assets. So it is useful technique in industries where technical developments are in full swing necessitating the replacements at an early date.
(3) It is an adequate measure for firms with very profitable investment opportunities, whose sources of funds are limited by internal low availability and external high costs.
(4) It is useful for approximating the value of risky investments whose rate of capital wastage (economic depreciation and obsolescence rate is hard to predict. Since the payback period method weights only early return heavily and ignores distant returns, it contains a built-in hedge against the possibility of limited economic life.
(5) When the payback period is set at a large number of years and streams are uniform each year, the payback criterion is a good approximation to the reciprocal of the in rate of discount.
Disadvantages of Payback Method
This method has its own limitations and disadvantages despite its simplicity and rapidity. Here is a number of demerits and disadvantages claimed by its opponents
(1) It treats each asset individually in isolation with the other assets. While assets in practice can not be treated in isolation.
(2) The method is delicate and rigid. A slight change in the division of labor and cost of maintenance will affect the earnings and such may affect the payback period.
(3) It overplays the importance of liquidity as a goal of the capital expenditure decisions. While no firm can ignore its liquidity requirements but there are more direct and less costly means of safeguarding liquidity levels. The overlooking of profitability and over-stressing the liquidity of funds can in no way be justified.
(4) It ignores capital wastage and economic life by restricting consideration to the projects’ gross earnings.
(5) It ignores the earning beyond the payback while in many cases these earning are substantial. This is true particularly in respect of research and welfare projects.
(6) It overlooks the cost of capital which is a main basis of sound investment decisions.
(7) It overstates the worth of flows within the payback period in that it assigns implicit equal importance to cash flows at the end of year 1 and year in.
In perspective, the universality of the payback criterion as a reliable index of profitability is questionable. It violates the first principle of rational investor behavior-namely that large returns are preferred to smaller ones. However, it can be applied in assessing the profitability of short and medium term capital expenditure projects.
