How payback period influences investment decisions

Author: Iloka Benneth Chiemelie
Published: 4th of October 2014

1.      Introduction

In the accounting setting, payback method is used to reference time (normally expressed in the form of years), that is required for cash income from any given capital investment project to equal initial cost of setting up such investments (Boundless Finance, 2014). Normally, the shortest payback periods are accepted but such decision have numerous setbacks as discussed below.

2.      Issues with the payback method

One of the issues with payback period is that it does ignore the time value of money. For instance, two projects can be seen as being equally attractive just because they have the same payback irrespective of when the payback can occur. Assuming that each of the projects required $100,000 initial investment, but the first project has a payback of one year and the second has a payback of three years, the projects can be seen as being equal, but in essence the first project is more valuable because it does have additional interest that could be earned from such investment for the second and third years (Boundless Finance, 2014 Accounting Explained, 2014 Jim and Demand, 2014).

Additionally, payback does ignore cash flows that exist beyond the payback period and eventually ignoring the profitability of the project. As a result of that, it is possible for one project to have more value than other based on the valuation of their future cash flows, but the payback doesn’t have necessary backings to capture this.

There are also complexities that arise from cash flow as it changes signs over the course of time (this is to say that it does contain outflows in the middle or at the end of a project lifetime). In any case, it is possible to apply modified payback algorithm at this period. It starts with first calculating the outflows (Boundless Finance, 2014 Accounting Explained, 2014 Jim and Demand, 2014). Then followed by the cumulative positives cash flows being determined over the period of time. The modified payback is determined as the period in which the cumulative positive cash flows does exceed the total cash outflow.

3.      Mitigating these negative effects while using payback period

The payback period is an analytical tool with serious limitations and qualifications required for its use as it doesn’t account for the time value of money, financing, risk, and other vital considerations like opportunity cost. Thus, it is recommended that the time value of money should be rectified by applying a weighted average cost of capital discount. Additionally, it is recommended that this tool should not be used in isolation. Alternative methods have been suggested by economist to include NPV and IRR – as these methods will help to better calculate the expected return irrespective of time required to effect such returns (Jim and Demand, 2014).

4.      Conclusion

Payback method is vital because it helps investors to determine when they are expected to leverage their investment. However, it does have the issue of ignoring the time value of money and neglecting some returns that can be acquired when comparing between two investments. However, these issues can be resolved by combing the payback method with other “return” tools such as NPV and IRR in order to better measure value of investment while also determining the time frame that such returns will be generated.

5.      References

Accounting Explained (2014). “Payback period: managerial account.” Available at: http://accountingexplained.com/managerial/capital-budgeting/payback-period [Accessed on: 13^th of September 2014].

Boundless finance (2014). “Disadvantages of the payback method.” Available at: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-budgeting-11/payback-method-92/disadvantages-of-the-payback-method-400-4251/ [Accessed on: 13^th of September 2014].

Jim Woodruff and Demand Media (2014). Advantages & Disadvantages of Payback Capital Budgeting Method. Available at: http://smallbusiness.chron.com/advantages-disadvantages-payback-capital-budgeting-method-14206.html [Accessed on: 13^th of September 2014].