Pay Back Period Method Explained | Capital Budgeting
What is Pay Back Period
The pay back period determines how long it will take to make back the initial investment. The PB shows how many years are needed for the cash inflows to equal the one million dollar outflow, for instance, if a capital budgeting project calls for a $1 million beginning cash outlay. A brief PB term is preferable since it suggests that the project would “pay for itself” more quickly.
The PB term in the next case would be three and a third years, or three years and four months.
When liquidity is a key concern, payback periods are frequently used. A corporation could only be able to take on one significant project at a time if it has a certain amount of funding. As a result, management will put a lot of effort into getting their initial investment back in order to move forward with new projects.
Once the cash flow estimates have been produced, another significant benefit of employing the PB is that calculations are straightforward.
Limitation of Pay Back Period Method
The PB measure has limitations when used to make capital budgeting decisions. First off, the time value of money is not taken into account by the payback period (TVM). A statistic that equally emphasizes payments made in years one and two is provided by computing the PB.
Such a mistake goes against a fundamental tenet of finance. Fortunately, this issue is easily resolved by using a discounted payback period model. Basically, the discounted PB period takes TVM into account and lets you calculate how long it will take to repay your investment on a discounted cash flow basis.
Another disadvantage is that both payback periods and discounted payback periods neglect cash flows like salvage value that happen toward the conclusion of a project’s life. As a result, the PB is not a precise indicator of profitability.
The PB duration in the following example is four years, which is worse than the PB period in the preceding example, but the significant $15,000,000 cash influx occurring in year five is disregarded for simplicity’s sake.
The payback technique has additional limitations, such as the potential requirement for monetary investments at various project stages. Additionally, the asset’s lifespan should be taken into account. There could not be enough time to make money off the project if the asset’s life does not last very long after the payback period.
The payback time is typically regarded as the least pertinent valuation approach because it does not take into account the extra value of a capital budgeting choice. However, PB periods are crucial if liquidity is an important factor.