The payback period: Investments (viability techniques)
The payback period of an investment project indicates to the investor the number of years required to recover the initial cash investment bases on the project’s future cash flows.
If the payback period of the initial investment in within the accepted time frame the project is deemed viable from the investor’s point of view, if not, it is not deemed as viable.
One of the shortcomings of the payback period methodology is that it does not take into consideration the cash flows beyond the pay back period time frame. Hence the Payback Period (PBP) is not the true measure of profitability.
Let us look at an example:
Two proposals costing $ 20,000 each have the same payback period of 2 years assuming that both have annual cash in flows on $ 10,000 in the first two initial years.
But the first project might not have any cash flows beyond year 2 where as the second project might have cash flows beyond year 2 (extending up to year 5).
The Payback period can be a deceptive yardstick for profitability.
Moreover it also does not recognize the time value of money. The maximum payback period which shall be treated as the cut off is also subjective.
