Definition: The Payback Period helps to determine the length of time required to recover the initial cash outlay in the project. Simply, it is the method used to calculate the time required to earn back the cost incurred in the investments through the successive cash inflows.
The formula to calculate it:
Payback Period = Initial Outlay/Cash Inflows
Accept-Reject Criteria: The projects with the lesser payback are preferred.
Merits of Payback Period
- It is very simple to calculate and easy to understand.
- This method is helpful to analyze risk, i.e. to determine how long the investments will be at risk.
- It is beneficial for the industries where the investments become obsolete very quickly.
- It measures the liquidity of the projects.
Demerits of Payback Period
- The major drawback of this method is that it ignores the Time Value of Money.
- It does not take into consideration the cash flows that occur after the payback period.
- It does not show the liquidity position of the company, but only tells the ability of a project to return the initial outlay.
- It does not measure the profitability of the entire project since it only focuses on the time required to recover the initial investment cost.
- This method does not consider the life-span of investment, what if the life of an asset gets over very much before the initial investment cost is realized.
Thus, the payback period is the simplest method to assess the risk associated with the investment and the time required to get the initial outlay recovered.