What is the payback criterion decision rule?
What are the problems associated with using the payback period as a means of evaluating cash flows?
What are the advantages of using the payback period to evaluate cash flows?
Do not plagiarize!
Payback Period
Question 1
The payback period is essentially the break-even point following a sequence of successive cash flows. Principally, when computing the payback period, an assumption is made that any cash flow that occurred within a certain period was realized consistently and continuously all through that period, and not at a particular point in time. As such, the formula for determining payback is simple: the cash outlay is divided by the annual net cash inflow that the given project generates. Accordingly, the payback is the particular point within the series of cash flows at which the initial expenditure in terms of savings or profits is recovered in totality.
Question 2
Fundamentally, there is usually a predetermined deadline within which the payback period should fall. Thus, the decision rule is to agree to undertake projects that promise to break even before the deadline and dismiss those that would fall outside the preset cutoff.
Question 3
The payback period does not take into account the time value of money as it is basically determined by enumerating the years within which the invested capital would be recovered. Additionally, choosing the hurdle rate for this method is largely arbitrary and is devoid of any straightforward method or rule. Further, this approach ignores all the benefits accrued after the cutoff period elapses. Thus, it would not bring out the true picture for short-term projects.
Question 4
The payback period is commonly used as it is very simple and straightforward to calculate because the pertinent accounting figures or projections are readily available. Moreover, the method can be used as an indicator of intrinsic risks in a project. Due to the perceived uncertainty of the cash flows occurring later as the project progresses, the payback period offers a measure of the certainty of a project’s cash inflows. Additionally, the payback method’s biasness towards liquidity makes it a good tool for ranking projects with the potential to break even early and is thus appropriate for companies battling liquidity issues or short-term projects to careful spending is critical.