The Payback Period Method of Capital Budgeting
The payback period method of capital budgeting technique is an essential aspect that many organizations utilize in projecting their expected rate of returns from an investment. The payback method attempts to highlight the time it would take for a project to recover its initial cost of investment. Before organizations undertake a particular project, they consider the payback period in assessing the extent to which the project would bring back its initial cost. As such, the payback period method can be used to either accept a project or reject its implementation based on the expected rate of an investment over time. Since the payback period method fails to consider the value of money, projects with lower payback periods are often regarded as more feasible than investments with longer payback periods (Andor, Mohanty "Toth, 2015).
Advantages of the Payback Method
Furthermore, the payback method is a simple and easy-to-use approach that provides an opportunity for managers to calculate the potential risk for a prospective investment. Project managers can often assess how best to acquire the raised amount of capital utilized for investment in short-term projects. Moreover, in evaluating the payback period of a project, the cost of investment is considered as a fundamental variable in the proposal (Al Ani, 2015). The payback period necessitates the calculation of the annual net cash flows from the investment while reducing the potential impacts of the noncash incomes from the project. In computing the payback period, the difference between the cash revenues and cash expenses are averaged form the cost of the machine to determine the annual rate of return. Nonetheless, the payback period exhibits various drawbacks (Al Ani, 2015). First, it fails to account for the revenues that would be obtained after the payback time. Second, the method only relies on quick recovery through profitability measures while failing to consider a firm's performance over the period.
References
Al Ani, M. K. (2015). A Strategic Framework to Use Payback Period (PBP) in Evaluating the Capital Budgeting in Energy and Oil and Gas Sectors in Oman. International Journal of Economics and Financial Issues, 5(2), 469-475.
Andor, G., Mohanty, S. K., " Toth, T. (2015). Capital budgeting practices: A survey of Central and Eastern European firms. Emerging Markets Review, 23, 148-172.
