Payback method refers to the period of time it takes for the cash flows to cover the initial cost of investment or recoup the initial cost of investment. The period is usually calculated in years.
Required:
Identify TWO advantages and TWO disadvantages of using the payback method in investment appraisal? (4 marks)
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Advantages:
- Simple and easy to use.
- It gives indication of the liquidity. The earlier the payback period the better the liquidity.
- It broadly measures the risk of the project. The earlier the payback period the better the risk.
- Is faster to compute
Disadvantages:
- It ignores the time value of money.
- Ignores the cash flows after the payback period and may discriminate against projects that have significant cash flows after the payback period.
- It ignores the residual value and total economic life of the project.
- Determination of the payback period upfront could be subjective and discretionary.
- It measures mainly recovery of capital and not profitability of the project.