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Payback Method

The payback method could be called "investment decision making for dummies." It is a popular and easy method, and can be valuable when the key investment goal is to find projects where the initial investment is quickly recovered. But, it is not very strong in otherwise pinpointing the best capital investment decisions.

Payback is calculated by dividing the initial investment by the annual cash inflow. The earlier illustration for Greenspan has a payback of approximately 3.9 years ($500,000/$128,000 = 3.9). If an investment involves uneven cash flows, the computation requires scheduling cash inflows and outflows. The payback period is the point at which the cumulative net cash inflows begin to exceed the cumulative net cash outflows.

The method is deficient in that it does not take into account the time value of money. It also fails to reveal what happens after the payback period. For example, some investments may payback rapidly, but have little residual cash flow after the payback period. Other investments may take years to payback, and then continue to generate future returns for many more years to come. Although the investment with the shorter payback may be viewed as favorable, it could easily turn out to be the worst choice. All in all, be very cautious using the payback method for making business decisions.

Conclusion

Capital budgeting decisions are not much different than the whole of managerial accounting. There are many tools at your disposal. You should understand these tools and how to use them. But, in the final analysis, good decision making will be driven by your own reasoned judgment.

 
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