Monday, February 1, 2010


Disadvantages of Payback

In spirit of its simplicity and the so-called virtues, the payback may not be a desirable investment criterion since it suffers from a number of serious limitations:
  • Cash flows after payback. Payback fails to take account of the cash inflows earned after the payback period.
  • Cash flows ignored. Payback is not an appropriate method of measuring the profitability of an investment projects as it does not consider all cash inflows yielded by the project.
  • Cash flow patterns. Payback fails to consider the pattern of cash inflows. I.e. magnitude and timing of cash inflows. In other words, it gives equal weights to return of equal amounts even though they occur in different time periods.
  • Administrative difficulties. A firm may face difficulties in determining the maximum acceptable payback period. There is no rational basis for setting a maximum payback period. It is generally subjective decision.
  • Inconsistent with shareholder value. Payback is not consistent with the objective of maximizing the market value of firm’s shares. Share values do not depend on payback periods of investment projects.

Let us re-emphasize that the payback is not a valid method for evaluating the acceptability of the investment projects. It can, however, be used along with net present value (NPV) rules as a first step in roughly screening the projects. In practice, the use of discounted cash flow (DCF) techniques has been increasing but payback continues to remain a popular and primary method of investment evaluation.

Payback is considered theoretically useful in few situations. One significant argument in favor of payback is that its reciprocal is a good approximation of the rate of return under certain conditions.

No comments: