A payback period is a common method used by organizations to determine how long it will take to recoup money spent on a project. This method has advantages, but it also has drawn many criticisms from analysts and business owners.
It is calculated by dividing the total cost of the project by the annual cash inflow. Projects that have shorter payback periods are considered less risky because they are more liquid and allow businesses to recover the investment made into the project faster. Companies often feel that if a project has a payback period of one year or less, the project is a necessity and should be completed.
One criticism of the payback period method is that it only takes into consideration the return of the project during the payback period. After the payback period ends, it ignores all benefits of the project thereafter. Therefore, if a company is considering two different projects, it should look at the total benefits expected of each project.
Time Value of Money
Another common criticism of this method is that it ignores the principle of time value of money. This method bases cash inflows in the future as equal to cash inflows today, which is not necessarily true. Cash that a company receives today is most likely more valuable than cash received in the future, due to inflation and other factors. Therefore, the expected cash inflows should be evaluated based on when the cash is expected. Companies should value a project that has a higher cash inflow sooner than one that expects a cash inflow at a later period.
Comparing Other Factors
Sometimes this method is criticized because one or more important factors are not considered when making a decision about an investment. For example, assume a company is looking at purchasing a machine and has narrowed its options down to two. Both machines have the same payback period, but are not necessarily equal. If one machine has a higher estimated useful life, it will continue to offer benefits long after the other one would. This criticism is common, and is often overlooked by organizations.