Limitations, or disadvantages, of using the payback period method in capital budgeting include the fact that it fails to take into account the time value of money and does not factor in the value of additional cash flows beyond the payback period. Capital budgeting is an important decision-making process as companies seek to grow and expand their market. One analysis tool used to evaluate proposed capital expenditure investments is the payback period.
Payback Period Analysis
The payback period examines investments in terms of the time it takes for the cash flow of income from the investment to equal its initial cost. When considering two similar capital investments, a company is inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment. Some companies rely heavily on payback period analysis and only consider investments for which the payback period does not exceed a specified number of years.
Payback period analysis is favored for its simplicity. This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time.
Limitations or Disadvantages of Payback Period Analysis
Despite its appeal for some reasons, the payback period analysis method has some significant drawbacks. The first is that it fails to take into account the time value of money and adjust the cash inflows accordingly. An inflow return of $15,000 from the investment that occurs in the fifth year following the investment is viewed as having the same value as a $15,000 cash outflow that occurred in the year the investment was made despite the fact the purchasing power of $15,000 is likely significantly lower after five years.
Also, the payback analysis fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another. For example, two proposed investments might have similar payback periods, but cash inflows from one project might steadily decline following the end of the payback period, while cash inflows from the other project might steadily increase for several years after the end of the payback period. Since many capital investments provide investment returns over a period of many years, this can be an important consideration.
The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows thereafter. Additional cash outflows may be required over time, and inflows may fluctuate in accord with sales and revenues.
Due to its limitations, payback period analysis is sometimes used as a preliminary evaluation, and then supplemented with other evaluations, such as net present value (NPV) analysis or the internal rate of return (IRR).