Q 684. What is Payback Period and how does it help in project selection? What are its advantages and disadvantages?

 

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Payback period is one of the simplest method to measure project profitability and risk.  Payback period simple meaning is time taken to recoup the initial investment.  It is useful when company has limited resources and need to know how quickly they will recover their investment. 

 

Calculation of payback period = Initial investment / Annual cash flow. 

 

Since payback period is very simple compare to other investment investment or project appraisal techniques.

 

a. for example IRR ( Internal rate of returns) help to analyze and compare the incremental profit  in terms of rate of returns Vs. Risk to be taken for example. if we invest same amount of money in to Financial market ( Equity/ Debt) we may get average 10% IRR Vs. Project should reflect 5-7% incremental returns for efforts, time and risk taken on the project to justify the project selection. 

 

b, Net Present Value indicates difference between present value of cash inflow and cash outflow. Here NPV of any project negative then you should not accept the project is thumb rule.

 

While projection selection all three method or financial metrics can be use but payback period suits to organization with limited resources and high intensity cashflow/ liquidity requirement. 

 

Lets understand advantages and disadvantages of using Payback period while project selection.

 

Ram wanted to open Small Cafe. He needs 1000000 ( 10 Lakhs) as initial investment. He tells his friends and relatives invest in this business as it will give him 100000 ( 1 Lakhs) profit every month. 

 

Payback period = 10 Lakhs/ 1 Lakhs = 10 Months.  Now the funny part 

 

1st Month Ram Open Cafe earns 1 Lakhs 

 

2nd Month there was big event like fun fair, exhibition happened near to his cafe. Profit for this month increase to 2 Lakhs. 

 

3rd Month there was coronavirus 2nd Wave hit and all shops, cafe were closed for month. So No Profit.

 

4th Month, 5th and 6th month his profit was again 1 Lakh per month.

 

7th and 8th Month there was 3rd Wave of COVID 19 so no profit

 

9th and 10th Month there was bulk order from big corporate event leading to profit of 3 Lakhs .

 

So Profit so far is 9 Lakhs and still need 1 more lakh profit for Break even. Considering up and down his relative were very happy and start taking more bets on his idea and encouraging him to expand his cafe chain by opening 1 more outlet, delaying the payback further. 

 

So learning here payback period is simple and help assess risk of investment but it ignore

 

1. Time value of money 

2. Cash flow after payback 

3. Doesnt measure profitability. 

 

 

So Payback period is useful when liquidity is highest priority .

Payback period highlights in years, the time taken for the investment to payback itself, ie to breakeven. Beyond Payback period, businesses can start accruing profits, and it is important to know how soon this time can start.

As the name indicates, Payback period = Initial Investment/ Annual Cash flow.

As a means of comparison, higher the payback period, less lucrative the investment.

 

The biggest advantage of this metric is the ease of its calculation, and hence it comes in very handy to compare various options, in our case, project selection.

On the other hand, the biggest disadvantage of this method is that it ignores time value of money. Simply put 100 units of currency are worth more today than in future. This can be easily accounted in NPV thereby making it a better metric to use.

Ramdas has provided the best answer to the question. He has explained the concept with a very good example. Well done!