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Limitations of using the Payback Period in evaluating an investment
Despite being a popular tool of investment evaluation, payback is not applicable in all investment evaluation projects. In this article, we will highlight some of the shortcomings of using the Payback Period in evaluating an investment.
Cash Flows after Payback
The payback period fails to consider the cash inflows after the payback period is over. As in the calculation of payback, the year in which the cash inflows become positive is considered as the payback year, and the cash inflows occurring in subsequent years are ignored. This leads to the erroneous calculation of cash inflows and returns on investment.
Missing the calculations of cash inflows is the biggest shortcoming of the payback method.
Cash Flows Ignored
As is mentioned above, the payback method may ignore cash inflows occurring during the project. Cash inflows are an important tool for measuring the effectiveness of a project. However, this aspect is not considered in case of payback. Therefore, payback is a less efficient measure to evaluate an investment.
Cash Flow Patterns
The payback method does not offer any idea of the magnitude and timing of cash inflows. As payback does not consider the time value of money, it considers all cash inflows to be equal in value irrespective of the time when it occurs. It may offer erroneous results, as the money obtained a year later than the given one (present) is less in value, if we apply the concept of time value of money.
This is applicable to the magnitude of investments too. Payback may be less efficient in determining the value of a high-value investment in comparison to a low-value one.
There are administrative difficulties in applying the payback method. There are no hard and fast rules for having the maximum acceptable payback period which makes it difficult for managers to have a rational basis for the investments.
The payback method just cares for investments irrespective of their magnitude, timing, and maximum acceptable payback which makes the outcome flawed in terms of the exact value of investments.
Although payback is a popular method for non-financial managers, it is hard to calculate exactly, as there are no administrative norms for calculating the payback periods.
Independent of Shareholders’ Value Maximization
Payback has nothing to do with shareholders’ value maximization. The shareholders’ value does not affect the payback method in any way. This is probably the biggest disadvantage in the case of bigger companies that have a higher focus on shareholders’ value maximization as one of their ideal policies.
Therefore, payback is not an ideal investment evaluation tool for corporate firms that have strong shareholders’ value maximization policies intact as their primary objective.
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