Pay Back Period method

Pay back period method

• This is such a technique which determines the project which will tell us the
repayment of the initial investment in the shortest possible time
• Pay back period is that period- where the total earnings or net cash flow from
investment will be equal to the total money spent-required to recover the
initial cost of investment
• Mathematically- the ratio of of the initial investment to annual net cash flow
• Symbolically P=I/C P= Pay back period, I= Investment and C= Yearly net cash
flow
• Though there is a relation b/w PBP & BEP they are different-the BEP is the
price or value that a project must rise to cover the initial cost –while PBP refers
to how long it takes to reach that Break Even.
Features of the Pay Back Period technique
• Used to compare among the different projects that are available and to derive the number of
years each of the project will take to get back the initial investment
• The project with least no of years will be selected
• Management starts with the decision of the time period with in which it would like to recover
the initial investment known as Thresh hold pay back period
• If the actual pay back period of a project is less than or equal to the thresh hold back period then
the project is accepted otherwise rejected
• If there are two projects both having actual pay back period less than the thresh hold pay back
period, the project with a smaller actual pay back period amongst them will be preferred
• Owing to its simplicity this method is used in combination with other techniques in deciding
about the project to be selected
• The best payback period is the one which repays the initial investment in the shortest period of
time
Advantages of the Pay Back Period technique
1. It is easy to calculate and simple to understand
2. Projects under this method are ranked in terms of their eco merits
3. Very much useful in case of uncertainties like technological change or instabilities in business activities
4. Very much useful for cash poor firms because :
a) an investing firm needs to make a snap judgement about
an investment
b) it gives more importance to the speedy recovery of investments
in capital assets
c) it helps to improve the liquidity position of the business quickly
d) it makes the fund available soon to invest in other projects.
5. It is very much liked by the Executives because:
a) management wants early recovery of investments
b) it gives quick answers to the business decisions on investment
c) it reduces the loss of risk caused by the changing economic conditions
d) it helps in cases where profitability is not given much importance
Disadvantages of the Pay Back Period
technique
1. Over emphasizes the importance of liquidity undermining
the importance of profitability
2. It does not distinguish b/w cash flows at different points of time
3. It does not take in to account the time value of money i.e. the effects
of inflation or the complexity of investments that may have unequal
cash flow over time
4. It does not consider the useful life of the assets because it ignores
the annual cash inflow after the pay back period(for example 2
projects A&B with an initial investment of Rs 5000 each will have a
cash inflow of Rs 1000 each. But A generates for 5 years & B generates for
7 years. Here project B is more profitable )
5. It over looks the cost of capital(interest) which is an important factor in investment
decisions
6. It leads to administrative difficulties like:
a) minimum acceptable pay back period is generally decided by the management on subjective factors rather than on a rational
basis
b) a slight change in the operational cost will affect the cash inflow which in turn will affect the pay back period.