Payback Period Method and Its Applications - Assignment Example

PAYBACK PERIOD METHOD AND ITS APPLICATIONS A payback period method helps manager in making capital budgeting decisions. As it gives a mangers the estimation about the time required by an investment project to repay its original cost out of the cash inflows it generates (Warren, Reeve, & Duchac, 2011). The shortest the time period for payback the greater the investment project will seek to be enchanting to managers because it reflects that the investment project is generating larger profits in lesser time. Most of the companies choose those projects that cover up all its initial cost within the project time period. It is donated in terms of years and if the cash inflows are same every year then following formula will be used for evaluation of payback period. Formula: The payback period can be extracted from the formula: Payback period = investment undertaken / net cash flows annually Let’s take an example to clarify the concept: For example: MR Yuiko, manager finance department, wants to undertake an investment and for that he buy a chaff cutter for his business. He had two options either to buy machine1 which cost 200,000 and gives the return of 40,000 annually. Whereas, machine2 cost 150,000 and gives the return of 20,000 annually. Mathematically: Project A (Machine1): 200,000 / 50,000 = 4 years Project B (Machine2): 150,000/ 30,000 = 5 years According to the payback period decision Mr. Yuiko should undertake project A since it has shorter payback period than project B. we can see clearly that how easy it was for the manager to make a decision for investment by simple payback period method. The payback period gives a manager an estimation that how long will his investment take to recover his initial costs. Making decision on the basis of single information is not a watchful decision, he must also heed over other aspects of investment because it is not always the case. Moreover; under certain stipulations the payback can be sort to be beneficial. Like to those firms that stands at the position of “cash poor” since they want the immediate return of their investment hence there the low return with lesser payback period is weighted more than the higher return with longer payback period (Garrison, Noreen, & Brewer, 2009). It is also preferred in those industries in which the products may defunct shortly, only a year or two, then the payback period may be considered important. The manager must also be aware about drawbacks of the payback period method because it not always draws a true picture for the manager to portray about the investment project. A manger must not always think that the project with shorter time period is always the lucrative decision to undertake. Let’s take an example to clarify the confusion: Now; if Mr Yuiko, manager finance is provided with more details about the machine he will easily be able to overcome this illusion. Although Project A seem to have lucrative returns according to payback period than project B but what if he now comes to know that project A has the life expectancy of 10 years and project B has 15 years, then he can easily figure out which project to choose as best. Under such specifications his answer would surely be B because rationally it is much better investment than A even if project A has lesser payback time. This means that payback period method fails to signal a manager in distinguishing the useful life span between investment projects. Secondly; when considering payback method the manger must also be aware that this technique disregards the time value of money. It values the amount of money (cash inflows) today exactly equal to the amount of money (cash inflows) after several years. Let’s take an example Mr. Yuiko wants to invest $40,000 in a stream. He has following option available. Which option will he undertake? Years 0 1 2 3 4 5 6 7 8 Option1 10,000 10,000 10,000 10,000 40,0000 Option2 40,000 10,000 10,000 10,000 10,000 He would surly opt for option 1 because each option has same time period of 4 years and according to time value of money option 1 is much better than option 2 but if as a manager you were to rely with payback period then u were coerce to see each option equally desirable. The payback period is also sort to be useful even when a company generates different cash flow amount from an investment from year to year then he can simply use following steps to estimate his investment payback period (Eisen, 2000). Let’s illustrate an example to understand. Year Investment Cash flows 1 $8000 $2000 2 0 3 4000 4 1000 3000 5 2000 6 1000 7 2000 8 3000 The payback period for this investment is 4 years. To achieve this result it is necessary to show the step by step unrecovered amount per year results as shown below: Years Beginning Unrecovered Investment investment Cash inflows Ending Unrecovered Investment (1) + (2) - (3) 1 $0 $8000 $2000 $6000 2 6000 0 6000 3 6000 4000 2000 4 2000 1000 3000 0 6 0 2000 0 7 0 1000 0 8 0 2000 0 There are several reasons why a manger opts for payback method. Firstly; it has simplicity to make capital budgeting decisions. Using this approach a manager doesn’t need to hire various employees from diversified background in order to evaluate the investment projects. He can evaluate the projects easily with lesser people and in shorter time. He can identify that which project is lucrative enough to investment in and which to choose the best, also the need of rigorous economic analysis curtails. It make an investment decision making simple and easily perceivable for manager as it gives a sketch to him in making capital budgeting decision, especially if a manager faces any dilemma in choosing a project out of two then he can overcome the problem immediately using the same approach (read above example for the clarification). It also protects a manager from any risk related to the project because it may be possible that a manager undertakes a project which generate low income than the initial cost for example if a investment has a payback period of 5 years and the life span of the machine in which the money is investment is 4 years only then the manager may face a huge loss, but if he is aware about all such circumstance than he would avoid such investment, hence the method can help him decide that in which project to further investment and where not. Therefore, it is necessary for a manger to learn this technique and avoid wasting money by undertaking any uneconomical investments (Hilton, 2009). With all above benefit there are some shortcomings of payback period and he must also be aware about them because keeping them in mind he can make more rational decisions that he should remember that it ignores the time value of money so this means that the total value of money today is more than the total value money tomorrow. Secondly; a manager must not omit a lucrative investment project if only the payback method is taken into consideration. The reason is that the technique only focuses on short term profitability, however; there may be a possibility that the projects with longer payback period will generate more income due to its longer life span than the project with shorter payback period. Bibliography Eisen, P. (2000). Accounting. Barrons Educational Series. Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2009). Managerial Accounting. McGraw-Hill/Irwin. Hilton. (2009). Managerial Accounting 7E. Tata McGraw-Hill Education. Warren, C. S., Reeve, J. M., & Duchac, J. (2011). Managerial Accounting. Cengage Learning. Read More