One advantage of the Payback Period Ratio is its simplicity of calculation and understanding. Nevertheless, it has two major defects:
It ignores any benefit that may occur after the payback period
It ignores the Time value of Money
Agree or disagree?
Please discuss and include references.© BrainMass Inc. brainmass.com December 24, 2021, 9:36 pm ad1c9bdddf
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The payback period ratio definitely has simplicity on its side as an advantage. The basic formula of the equation is, in fact an advantage as compared to the other methods most commonly used, which take ample amounts of time to calculate. The method to calculate the payback period ratio is:
Payback period = investment required / net annual cash flows.
This method focuses on recovering the cost of the investment. The payback period indicates the amount of time that it takes for a project financed through capital budgeting to recover the initial cost, but does not take other factors into consideration, including primarily the time value of money and benefits after the payback period has ended. It is not in any way a measure of true income to the organization. Under the other methods most commonly used, future incomes and levels of related risk can be measured. Under the payback period method, it does not indicate risk at all. This factor alone should be an important consideration for management in deciding if the organization should use the payback period ratio method, as opposed to the other methods, which can indicate risk, and to what degree the firm will assume, under the project being considered. The only substantial information that the payback period ratio tells management is how long it will take for the firm to recoup the invested money.
Due to the disadvantages present, other methods of capital budgeting are usually preferred, and are more commonly used, including the net present value method, (NPV), the internal rate of return method (IRR), or the discounted cash flows method.
In recent times, however, management teams that have wanted to take advantage of the payback period method but don't want to ignore the time value of money have adopted a variation on the payback period ratio, called the discounted payback period ratio. Under this new method, the discounted present value of the project's cash flows is used as the base to calculate the project's payback period, and considers the time value of money as part of the initial equation.
Polytechnic University of the Philippines. (2009). Capital Budgeting. Retrieved from http://capitalbudgeting.tripod.com/id24.html
Accounting for Management. (2011). Payback Period Method for Capital Budgeting Decisions. Retrieved from http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_decisions.htm.© BrainMass Inc. brainmass.com December 24, 2021, 9:36 pm ad1c9bdddf>