What are the advantages and disadvantages of payback period?

The basic element of Payback Period method is to calculate the recovery time, by year wise accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal the amount of the original investment. The time taken to recover such original investment is the “payback period” for the project. “The shorter the payback period, the more desirable a project”.

Advantages of Payback Period

1. No assumptions about future interest rates.
2. In case of uncertainty in future, this method is most appropriate.
3. A company is compelled to invest in projects with shortest payback period, if capital is a constraint.
4. It is an indication for the prospective investors specifying the payback period of their investments.
5. Ranking projects as per their payback period may be useful to firms undergoing liquidity constraints.

Disadvantages of Payback Period

1. Cash generation beyond payback period is ignored.
2. The timing of returns and the cost of capital is not considered.
3. The traditional payback method does not consider the salvage value of an investment.
4. Percentage Return on the capital invested is not measured.
5. Projects with long payback periods are characteristically those involved in long-term planning, which are ignored in this approach.