Describe the payback method and explain the pros and cons of its use as a decisionmaking
technique. Give an example where the method might produce a poor investment
decision and why the analytical tool might produce such misleading results.
1. Payback method
Payback method is an investment appraisal technique in capital budgeting. This method refers to estimate the recovery time of initial investment from the generated cash inflow by investment (Brigham and Houston, 2012). The formulas of payback method are as below:
1.1 Advantage of Payback method
Payback method contains many advantages for decision-making technique. It is easy to calculate and understand for individuals. For the evaluation and comparison of similar investment projects, this method is quite useful. Similarly, the investors can identify that project which is giving the fastest return on investment and will make the correct decision for invest.
This method also identifies the inherent risks of a project or deals with risk. In this way, if the payback period of a project is shortest in compare of other projects than the risks also will be less in this project (Smart et. al., 2016). Moreover, the entrepreneurs can increase financial liquidity by using payback method.
1.2 Disadvantage of Payback method
Payback method has numerous limitations which produce poor investment decisions and misleading results (Kuratko, 2016). This method ignores the time value of money and long term risk associated with the investment. Payback period method only calculates short term profitability and ignores long-term profitability. The investment start producing cash inflows after certain time and payback method does not consider future cash inflows.
Additionally, it ...
Payback is a useful investment evaluation method that is discussed in this response. Also, advantages and disadvantages of this method are analysed. Some examples have been provided.