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Payback Period as a Method of Handling Investment Risk
Payback period or simply payback in capital budgeting refers to the time required for the ROI (Return on Investment) to repay the original sum of investment.
Payback is a preferred tool because it is easy to understand and apply, irrespective of whether the manager is aware of financial calculations or not.
Payback is an effective tool to derive the worth of an investment when similar projects are compared.
The payback method is a simple tool to measure the months or years it takes to repay the initial investment of a project.
The payback method doesn’t have any specific criteria for the evaluation of investments as a standalone tool. The only necessity in using the payback period method is that the period should be less than infinity
Payback as a Method for Handling Investment Risk
Investment risks are a crucial part of the decision-making process for a large investment. Investors usually want to know how much time a project will take to return the original investment made in a project. This is simple to understand because the earlier a project starts paying back the money, the better it is for the investors.
The payback period is an easy tool to analyze the basic investment period for a return and it does not require any academic or practical knowledge. Therefore, it is a fairly popular tool to analyze the worth of an investment.
When compared with similar projects, the payback method offers an idea of how long or short it will take to be equally profitable with a similar project. It can therefore be compared whether the project in consideration is having a good ROI or not.
The payback period is a good way to measure the investment risk. The project with a shorter payback period is considered less risky than a project with a longer payback the returns of which are similar or identical. Payback periods of a different project become similar when their attributes are similar and so, it is easy to compare projects with identical features. Therefore, while measuring risk, comparing similar projects via payback is considered a good option.
Payback is also a good tool to measure the worth of small investments, as it does not consume time and effort like bigger and sophisticated projects. That is, we can compare two similar projects with less payback duration more accurately than projects that have longer payback periods. Therefore, it is a good way to compare the risks and returns of smaller projects with higher accuracy than the investments of longer duration.
In a nutshell, payback can be used as a fairly efficient tool to measure the risks of business decisions when the investments of two projects are known and the risk of one of these projects has to be ascertained by referring to the risks of the other project.
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