Question

Despite being conceptually unsound payback period is very popular in business as criteria for assigning priorities to investment projects. Explain.​

Answer 1

Explanation on Payback Period method of capital budgeting used in Businesses

Explanation:

• Payback period is one of the most popular and widely recognized traditional methods of evaluating capital investment proposals.

• It is the number of years it takes for a firm to recover its original investment from net cash flows.The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equal the total initial cash outlays.At that point in time,the investor has recovered the money invested in the project.

• It can be calculated as follows:

                      Payback period =         Initial Investment

                                                                                                       

                                                   After-Tax Annual Cash flows

• The following are the merits of using Payback period:

1. Computation and usage of this method is simple.
2. This method is quite important for those firms which are facing problems of cash shortage and finance their projects throughout loans.
3. Projects in which technological development is quite fast and there is more risk of obsolescence,then such projects are chosen in which the payback period is small.
4. This method uses cash flows rather than accounting profits which is more realistic.

• The following are the demerits of using Payback period:

1. There is more importance to liquidity rather than to profitability which is not right.
2. Only payback of original investment is considered and income arising after that period is not considered.
3. Ignores cost of capital which is considered as one of the most strong criteria for investments
4. Does not consider Time value of money.