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People considering investing in specific projects are interested in many questions, answering which gradually clarifies the potential effectiveness of investments. The first question in the evaluation of projects relates to determining the period for which the cost will be returned. Each investor is interested in when investments will pay off and begin to bring steady profit. The payback period indicator is used to assess the effectiveness of investments.
The payback period, usually measured by years, is required for the original investment in the project to be fully recovered. That is, this is the period after which the initial investments will begin to generate stable cash flow and allow the investor to make a profit ( The payback method, n.d.). The payback period is one of the critical parameters for making an investment decision. For its calculation, annual inflows and outflows of funds are considered. The period over which the total profit will be equal to the amount of investment is the searched result. The complexity of calculations depends on the stability and size of income and expenses. The method is popular in use, especially for small projects, due to its simplicity and understandability.
It is critical to consider that the scheme has two significant drawbacks. First of all, the method does not acknowledge such a factor as the time value of money. For example, two projects are treated as equally valuable even if their payback period is different. Secondly, revenues after the end of the payback period are also not taken into account, which leads to ignoring the projects profitability. To deal with the first problem, analysts use the discounted payback period method. Within this approach, the time value of money is applied using discounted cash flow analysis equation ( The payback method, n.d.). The discounted payback period is more accurate, and taking the time value of money into account can be of strategic importance.
Reference
The payback method. (n.d.). Lumen Learning. Web.
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