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What Is Payback Period in Financial or Accounting Practice?
Payback period is a simple, yet powerful tool to evaluate a project’s rate of return in financial or accounting practice. It looks at the number of years it takes to recover the cost of an investment. In payback period, cash inflows are viewed as a series of payments that recoup the amount of cash put initially. For instance, if an investment of 1000 dollars makes a cash flow of 500 dollars in its first year and a cash flow of 500 dollars in its second year, the payback period of such an investment will be two years.
What are the Advantages of Using Payback Period for Financial or Accounting Practice?
One of the biggest advantages of using payback period in financial or accounting practice is its simple use and fast computation. It is a straightforward way to evaluate investments, and thus makes for an easy decision-making. Secondly, it focuses on the risk associated with investment and it is an easy way to check it. Lastly, it ignores the time value of money which makes it the best tool to compare multiple projects with different cash flows.
What are the Disadvantages of Using Payback Period for Financial or Accounting Practice?
One of the disadvantages of payback period in financial or accounting practice is its disregard for the time value of money. It ignores the cash flows after the payback period of investment which means that the projects with long time horizons, high costs and low returns cannot be evaluated properly. Moreover, it cannot differentiate between projects with the same payback periods but different cash flows and time value of money. Lastly, it does not take into account the effects of variability and risk, thus leaving room for possible errors.
Overall, payback period is a simple and straightforward tool to evaluate cash flow investments when the risk is low and the cash flows are uniform. However, it cannot effectively evaluate longer term investments with high risk and irregular cash flows. In such cases, sophisticated methods such as net present value or internal rate of return should be used.
What is Payback Period?
Payback period is a capital budgeting method that allows companies and investors to review the amount of time required to recoup the cost of an investment. In simpler terms, the payback period is the time it takes for an investment to have a net present value of zero, meaning that investors will have recouped their initial investment. Payback period is sometimes considered to be a shorter-term measure that captures the time liquidity of an investment and is often used in combination with other capital budgeting techniques, such as net present value.
Advantages of Payback Period
Payback period advantages include the fact that it is very simple to calculate and understand the period required for a given investment. Furthermore, because of its simplicity, it does not involve the level of complexity and expertise that may be seen in other financial methods such as net present value. As such, payback period can be used by non-financial personnel within a company in order to quickly assess the potential of a given project. Investors may find the payback period calculation useful when engaging in projects with high risk and without accurate estimates for other capital budgeting techniques
Limitations of Payback Period
Unfortunately, the simplicity of the payback period calculation also reveals one of its limitations. Since the calculation only requires the timeline for an initial outlay, it does not accurately consider the cash flow after the payback period. Furthermore, because of the simplicity of the calculation, other factors that govern the decision of an investment such as the value of the cash flows after the payback period are not considered in the calculation. For these reasons, investors should consider payback period in combination with other financial concepts when making an investment decision.