posted by Anonymous on .
Assume a $4000 investment and the following cash flows for two alternatives. Under the payback method, which of the following would be concluded?
a. Investment X should be selected
b. Investment Y should be selected
c. Investment X and Y provide the same payback period
d. Neither investment is acceptable under the payback method
You need $200 more to recoup your initial investment of $4000, which you can get from the third year cash flow of $3700.
You only need the pro-rata amount, which will be $200/$3700 = 0.054 year
Pay back period for X = 2.054 years
You need only $2700 from second year to recoup your initial investment of $4000.
You only need the pro-rata amount, which will be $2700/$2800 = 0.964 year
Pay back period for Y = 1.964 years
Investment Y is a better choice based on payback method alone
Payback period is the amount of time required for an investment to generate cash flows to recoup its initial investment.
An investment is acceptable if its calculated payback is less than prescribed number of years for the said company.
Payback period suffer from some of the following disadvantages:
It ignore the time value of money
It determines to accept or reject projects on an ad hoc basis.
It ignore the cash flow beyond the cut-off period
Its biased against an long term project as compared to a short term.
Other methods such as NPV and IRR take into consideration the time value of money and risk involved in the project by discounting future cash flows.
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