Question 1 OR (a)

Payback period method: a critical evaluation

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 1 OR (a) · 4 marks

Critically evaluate the payback method as a way of evaluating long term projects. 4

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

  • CriticallyBoth sides: the strengths, the limits, then your own view.
  • paybackCash flows year by year in one table, then discount, then a one-line decision.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 The method and its decision rule 1 mark 2 min
  3. 2 Merits 1 mark 1 min
  4. 3 Demerits for long-term projects 1½ marks 2 min
  5. 4 Evaluation ½ mark 2 min

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The method. The payback period is the number of years a project takes to recover its initial investment from its cash inflows. With equal annual inflows it is investment ÷ annual inflow; with unequal inflows the inflows are cumulated until they equal the investment, the fraction of the last year found by interpolation. A project is accepted if its payback is no longer than a cut-off period set by management; between projects, the shorter payback is preferred.

Picture itPayback period method: a critical evaluation

1Rekha puts her savings into a juice cart—the jar on the counter starts empty.

Payback periodThe number of years a project takes to recover its initial investment from its cash inflows.

2Orange by orange, the jar fills back towards what the cart cost her.

Why it is a measure of liquidityHow quickly the funds locked in a project come back and can be put to other uses.

3The jar full, the counting stops—the measure never looks at all the selling still to come.

Why it is not a measure of profitabilityIt ignores the cash inflows after the payback period, however large.

Merits

  1. Simple to compute and to understand.
  2. Liquidity: its emphasis on early recovery shows how soon the funds locked in a project come back, which suits a firm short of funds or working in unstable conditions.
  3. Risk screen: distant inflows are less certain, so preferring early recovery screens out riskier projects.

Demerits, which matter most for long-term projects

  1. It ignores the time value of money: a rupee recovered in year 3 counts the same as one in year 1.
  2. It ignores the cash inflows after the payback period, however large or long-lasting, so a long-term project that keeps earning after recovery gets no credit for it.
  3. The cut-off period is arbitrary and the same for projects of different lives, so short-lived projects are favoured.
  4. Because it discriminates against projects whose inflows come later, it is not a measure of profitability.

Evaluation. Payback measures liquidity, not profitability. For long-term projects, whose benefits lie mostly beyond the early years, it can reject a project that adds value, so it should be used only as a supplementary screen alongside a discounted method such as net present value.

Where the 4 marks sit

#ComponentMarks
1The method and its decision rule1
2Merits1
3Demerits for long-term projects1.5
4Evaluation0.5
Total4
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