Payback period is one of the most appealing techniques of the capital budgeting. It is easy to calculate and gives you an idea when your investment will recover its initial costs. Payback period is easy to calculate however while using it for capital budgeting one must consider its limitations and flaws as described below.
It is impossible to calculate payback period if the positive cash inflows do not prevail over the cash outflows. For this reason payback has no use for the business having a pure cost only case. For a given cash flow stream there may be one or more than one pay back periods. In examples payback period is shown for a cumulative cash flows where the cash inflows are constantly increasing however in the real world that might not be the case as cumulative cash flows can also decrease from one period to the other period. In a case where the cumulative cash flow is positive in one period and negative in the next period there is formation of more than one payback periods.
Payback period does not give any information about the cash flows coming after the year of the payback. One investment may have a shorter payback period as compared to the other however the other may have greater cumulative cash flows after over the time. The calculation of the payback period does not acknowledge the time value of the money. Moreover it does not reflect the amount of money an investment is earning after payback period. In addition to above mentioned flaws payback period does not consider risk factors, financing or opportunity cost during its calculation. According to the finance and accounting expert payback period must not be used as the tool of analysis in isolation and must be used in coherence with other capital budgeting techniques. Most of the economists prefer Internal Rate of Return and Net Present Value in order to measure the rate of returns. Another flaw with payback period is that it does not provide comparisons to other investments or not making any further investment.