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Why is the Payback Method popular despite being a non-DCF method of investment evaluation?
The payback method is a non-DCF method for investment evaluation. However, it is quite popular among economists and financial managers due to some virtues mentioned below −
Simplicity
As the time value of money and discounted cash flow are not considered, payback is a simple standalone tool for the evaluation of investments. Also, payback is quite easy to calculate and understand which is why it can be used by non-financial managers too. Simplicity in calculation and use is probably the most notable virtue for the popularity of the payback method.
Cost-effectiveness
The payback method is not only simple but is also quite cost-effective to calculate and use. It costs less than most other sophisticated measures of investment evaluations that need the attention of many financial managers and the use of computers.
Most other DCF methods use discounted cash flow which requires complex calculations for the evaluation of investments. The payback method requires much less cost and manpower in the calculation, making it one of the most popular tools for investment evaluation.
Risk Protection
By having a shorter standard payback period, the risk of investment projects can be nullified. Therefore, the payback method can minimize the losses by using a guarantee in shorter payback periods.
As companies invest in multiple projects, the cash inflows and life expectancies are highly uncertain in many of them. In such circumstances, the payback method can become a tool for limiting the upper bound of risk. It must be noted that it is less about profitability and more about risk protection, wherein risk protection may be evident in the case of the payback method.
Short-term Effects
By using shorter payback periods, companies can ensure more favorable short-term effects on earnings per share (EPS). It is to be noted that this cannot be a wise long-term policy as the company may have to lose the future growth for the sake of current earnings. Increased EPS makes the company a more favorable investment destination for investors, and the payback tool can be used favorably to do so by the companies.
Liquidity
Liquidity is another important feature that makes the payback method a popular tool of investment evaluation. As the focus of the evaluation is short-term liquidity in investment projects, the payback method can ensure high liquidity in short-term investments. This helps the companies in investing the money in other projects where the investment of funds may be necessary.
Most payback projects are rich in liquidity that helps them use the cash in case of any urgent need, helping companies to stay ready for investments in more useful projects at any time.
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