The pros and cons of taking capital budgeting decisions based on payback period

 

Capital budgeting decisions are not straightforward. But the more you ponder over the strategies you adopt and fine tune them the better would the outcome be. Capital budgeting can be done in various ways. Different investors follow different strategies and use different tools in order to make decisions. Payback period based capital budgeting decisions are very popular. There are ups and downs to using this method in the evaluation.

What is a payback period based decision?

Given the simplicity of this method, it has been very popular. As the name indicates this is a strategy that relies on the evaluation of the payback period. It is the study of the duration required for the investor to get back the capital that is being invested. To know how much time it would take to earn back what was invested the investor should also understand the cash flow expected annually.

Benefits of Payback period based calculations

It is one of the most direct perspectives when anyone makes an investment. If you are a capital investor irrespective of the sum you invest you would be very much keen on knowing when you would be able to draw out the capital that you invest. This would be the simplest indication of the kind of growth to expect from the business.

When we talk investments most investors prefer a suitable amount of liquidity in all their investments. After all, money that is not at your disposal when you really need it might not be useful. The ease of recovering the investment indicates a good liquidity in the investment.

This direct method also acts as a quick way to compare the available options at hand. So as a capital investor if you have a handful of projects that require the same investment you would be able to pick one among them by comparing their payback periods.

Limitations

The long-term scenario of the cash flow is not studied. Cash flow pattern and volume increase as the company grows. Payback period based decisions would not take into account this pattern of growth and the cash flow that can be expected after the investment is recovered. To be specific the value of money keeps changing. The cash flow that occurs when the company just starts out is very important. There are some businesses that make profits in the early years while some that take a lot of time to stabilize and fetch better returns.