| 
  • If you are citizen of an European Union member nation, you may not use this service unless you are at least 16 years old.

  • You already know Dokkio is an AI-powered assistant to organize & manage your digital files & messages. Very soon, Dokkio will support Outlook as well as One Drive. Check it out today!

View
 

payback period

Page history last edited by PBworks 15 years, 5 months ago

Google Gadget error

 

 

Table of Contents:


 

Payback Period

 

Popular alternative to net present value analysis. But the problem is that this technique does not consider the time value of money, nor does it consider potentially large cash flows that occur AFTER the payback period. For example, if a project takes 5 years to payback, but has a massive inflow of cash in year 6...it might be a better project than one that pays back in 3 years, but then sees very little cash in the next years. the problem is that some potentially valuable long term projects will get rejected.

 

Payback period is popular in corporations that say "no projects will be accepted that don't pay back in 3 years", for example.

 

note that the goal of the financial manager is NOT to get your money back quickly, but to make the highest return on investment, and to increase the value of the firm. payback period method is not a good technique for this.

 

What cutoff date should you use? Unlike the net present value technique which uses market rates to determine the discount rate which is appropriate for the individual project, there is not a similar technique for payback period.

 

When to use the payback period

 

when a company is large, and the individual projects to evaluate are small, and need quick decisions. This is true if there are many, many similar decisions to make every month.

 

When evaluating managers is important. Using payback period, it is quick to see if the manager made a "good decision", but using the NPV analysis might take more time.

 

When a firm is very small, and cash is limited, so the payback of cash quickly is important to re-invest...then the payback period method is great.

 

But when the projects get bigger, and of more importance to the firm, then NPV analysis becomes more common and important.

 

Payback period is good as a screen for a mixture of investment decisions that firms face day to day.

 

 

Discounted Pay back method

 

discount the cash flows using the discount rate, and then add up to see how long it takes to break even. In this way, you are going to take slightly longer to break even because the discounted cash flows will be slightly less (accounting for the time value of money).

 

Same problems as above: does not consider the possibility of large cash flows after the break even point, and it still arbitrarily sets the break even date.

 

Question - once you have already discounted the cash flows to the present value...why not just add them up and do an NPV analysis?

 

Comments (0)

You don't have permission to comment on this page.