One disadvantage of the payback method is that it does not consider the time value of money

Definition of Non-discount Method of Capital Budgeting

A non-discount method of capital budgeting is one that does not consider the time value of money. In other words, all dollars earned in the future are assumed to have the same value as today's dollars.

Examples of Non-discount Methods of Capital Budgeting

One example of a non-discount method is the payback method, since it does not consider the time value of money. The payback method simply computes the number of years it will take for an investment to return cash that is equal to the amount invested. The computed number of years is referred to as the payback period.

To illustrate, assume that a company invests $100,000 today in a project that is expected to generate cash of $50,000 for two years followed by $10,000 per year for four additional years. Its payback period is two years ($50,000 + $50,000).

Assume that another investment of $100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000 per year for six additional years, its payback period is approximately 3.5 years ($20,000 + $20,000 + $40,000 + half of $40,000).

The payback method answers only one question: How long before the cash invested is returned? The payback method does not address which investment is more profitable. Note from our examples that the payback method not only ignores the time value of money, it ignores all of the cash received after the payback period.

Another example of a non-discount method in capital budgeting is the accounting rate of return method, which is similar to the return on investment (ROI).

[To overcome the above shortcomings, capital budgeting should include calculations that recognize the time value of money. These include (1) the net present value, and (2) the internal rate of return. These calculations involve discounting the future cash flows since a dollar in the distant future will be less valuable than a dollar in the near future, and both of those dollars have less value than a dollar today.]

Payback period advantages include the fact that it is very simple method to calculate the period required and because of its simplicity it does not involve much complexity and helps to analyze the reliability of project and disadvantages of payback period includes the fact that it completely ignores the time value of money, fails to depict the detailed picture and ignore other factors too.

In many businesses, capital investmentsCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more are obligatory. Say, as an example, investment in plant & machinery, furniture & fittings, and land & buildings, to name a few. But, such investments do incur a lot of money outlays. And business homes certainly are going to be anxious to know when they will recover such an initial cost of an investment. Below we have discussed some examples of payback period advantages & disadvantages to understand it better.

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Source: Payback Period Advantages and Disadvantages (wallstreetmojo.com)

Advantages

#1 – The formula is straightforward to know and calculate

You simply need the initial investment and the near term money flow information. The formula for calculating even cash flows or, in other words, the same amount of cash flow every period is:

Payback Period = (Initial Investment / Net Annual Cash Inflow)

Let us, now, see how easily it can be calculated under different circumstances –

Caterpillar Inc. is considering the purchase of furniture & fittings for $30,000. Such furniture & fittings encompass a useful life of 15 years, and its expected annual cash inflow is $5,000. The company’s preferred payback period is 4 years. You need to find the payback period of the furniture & fittings and conclude whether or not buying such furniture & fittings is desirable?

The answer will be –

= ($30,000 / $5,000)

Payback period = 6 years

Thus, it may be concluded that the purchase of such furniture & fittings isn’t desirable as its payback period of 6 years is more than Caterpillar’s estimated payback period.

#2 – Payback Period Helps in Project Evaluation Quickly

The Boeing Company is considering purchasing equipment for $40,000. The equipment has a useful life of 15 years, and its expected annual cash inflow is $40,000. But, the equipment has an annual cash outflow (including preservation expenses) of $30,000 as well.  The aircraft manufacturer’s desired payback period is 5 years. Should Boeing purchase the new equipment?

• Total investment = $40,000
• Net annual cash inflow = Annual cash inflow – Annual cash outflow = $40,000 – $30,000 = $10,000

Answer will be –

= ($40,000 / $10,000)

Payback Period = 4 years

Hence, it may be settled that the equipment is desirable as its payback period of 4 years is less than Boeing’s maximum payback period of 5 years.

In the aforesaid examples, the various projects generated even cash inflows. What if the projects had generated uneven cash inflows? In such a scenario, payback period calculations are still simple! You just need to first find out the cumulative cash inflow and then apply the following formula to find the payback period.

Payback Period = Years before full recovery + (Not recovered cost at the beginning of the year / Cash inflow throughout the year)

Suppose Microsoft Corporation is analyzing a project that requires an investment of $250,000. The project is expected to come up with the following cash inflows in five years.

Calculate the payback period of the investment. Also, find out whether the investment needs to be made if the management wants to recover the initial investment in 4 year-period?

Step 1

Calculation of cumulative net cash inflow –

Note: In the 4th year, we got the initial investment of $250,000, so this is the payback year.

Step 2

• Years before the full recovery takes place = 3
• Annual cash inflows during the payback year = $50,000

Calculation of not recovered investment at the beginning of the 4th year = Total investment – Cumulative cash inflows at the finish of the 3rd year = $250,000 – $210,000 = $40,000.

Therefore, Answer will be –

= 3 + ($40,000 / $50,000)

Payback Period = 3.8 years.

So, it can be concluded that the investment is desirable as the payback period for the project is 3.8 years, which is slightly less than the management’s desired period of 4 years.

#3 – Helps in Reducing the Risk Of losses

A project with a short payback period indicates efficiency and improves the liquidity position of a company. It additionally means the project bears less risk, which is significant for small enterprises with restricted resources. A brief payback period also curtails the risk of losses caused due to changes within the economic situation.

There are two varieties of equipment (A and B) within the market. Ford Motor Company wants to know which one is more efficient. While equipment A would cost $21,000, equipment B would value $15,000. Both the equipment, by the way, has a net annual cash inflow of $3,000.

Thus, in order to find efficiency, we need to find which equipment has a shorter payback period.

Payback Period of Equipment A will be –

= $21,000/$3,000

Payback Period = 7 years

Payback Period of Equipment B will be –

= $15,000/$3,000

Payback Period = 5 years

Since equipment B has a shorter payback period, Ford Motor Company should consider equipment B over equipment A.

• Any investments with a short payback period to ensure that adequate funds are available soon to invest in another project.

Disadvantages

• It doesn’t take Time Value of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more into consideration. This method doesn’t consider the fact that a dollar today is way more valuable than a dollar promised in the future. For instance, $10,000 invested for a period of 10 years will become $100,000. However, even though the amount of $100,000 may look profitable today, it won’t be of the same value a decade later.
• The method additionally doesn’t take into consideration the inflow of cash after the payback period.

The management of a firm is failing to understand which machine (X or Y) to buy as both of them need an initial investment of $10,000. But, machine X generates an annual cash inflow of $1,000 for 11 years, whereas machine Y generates a cash inflow of $1,000 for 10 years.

The answer will be –

Payback Period = 10 years

The answer will be –

Payback Period = 10 years

Therefore, just by looking at the annual cash inflow, it can be said that machine X is better than machine Y ($1,000 ∗ 11 > $1,000 ∗ 10). But, if we tend to apply the formula, the confusion remains as both the machines are equally desirable, given that they have the same payback period of 10 years ($10,000 / $1,000).

Summary

Despite its shortcomings, the method is one of the least cumbersome strategies for analyzing a project. It addresses simple requirements such as how much time period is needed to get back the invested money in a project. But, it’s true that it ignores the overall profitability of an investment because it doesn’t account for what happens after payback.

Recommended Articles

This has been a guide to Payback Period Advantages and Disadvantages. Here we discuss the top advantages & disadvantages of the payback period along with examples and explanations. You can learn more about financial analysis from the following articles –

• Dollar-Cost Averaging 
• Formula of Discounted Payback Period
• Capital Budgeting Techniques
• CVP Analysis