Advantages of the Payback Period
The payback period is a simple and widely used method for capital budgeting decisions, and it has several advantages:
- Simplicity: The payback period is straightforward to understand and easy to calculate, making it useful for quick assessments and comparisons between projects.
- Risk assessment: It helps in assessing the risk of an investment. Projects with shorter payback periods are generally considered less risky than those with longer payback periods, as the initial investment is recovered more quickly.
- Liquidity focus: The method emphasizes liquidity as it is concerned with cash inflows. This can be important for businesses where cash flow management is critical.
- Suitability for small businesses: Because of its simplicity, it is particularly suitable for small businesses or for projects where the exact estimation of cash inflows in future years is challenging.
- Useful for industries with rapid technological change: In industries where technologies change rapidly (like IT or electronics), the payback period can be a useful measure as it doesn’t consider returns after the payback period, which may be more uncertain.
However, while the payback period has these advantages, it also has significant limitations, such as not accounting for the time value of money or cash flows after the payback period, and not directly considering profitability. Therefore, it’s typically used in conjunction with other capital budgeting methods, like net present value or internal rate of return, to make investment decisions.
Example of the Advantages of the Payback Period
Let’s consider an example of a small business owner who runs a bakery.
The owner wants to purchase a new baking oven that costs $8,000. She estimates that the new oven will increase the bakery’s net cash inflows by $2,000 per year due to its efficiency and capacity to produce more baked goods.
To calculate the payback period, the owner would divide the initial cost of the oven by the projected annual net cash inflow:
Payback Period = Initial Investment / Annual Cash Inflows
Payback Period = $8,000 / $2,000 = 4 years
In this scenario, the payback period for the new baking oven is 4 years. This means that if the bakery can indeed increase its net cash inflows by $2,000 per year as expected, the cost of the oven will be fully recovered in 4 years. This gives the business owner a quick and straightforward understanding of when the investment in the oven will have “paid for itself”.
Now, let’s say the owner is considering a second oven option that costs less upfront ($6,000) but only increases net cash inflows by $1,000 per year. The payback period for this option would be:
Payback Period = $6,000 / $1,000 = 6 years
Using the payback period method, the owner may prefer the first oven because it has a shorter payback period (4 years vs 6 years), and thus, the investment is recouped quicker. However, other factors such as oven durability, maintenance costs, and energy efficiency should also be considered.
This example highlights the simplicity of the payback period method and its ability to provide a quick snapshot of an investment’s risk level (shorter payback periods often mean less risk). But remember, the payback period doesn’t account for the time value of money, nor does it account for cash inflows after the payback period is reached, so other methods should be used in conjunction with it.