Companies engage in capital projects as they grow. A capital project -- like the purchase of new equipment or building a facility -- involves a large financial investment from which the company expects to reap continued future financial gains. Companies use several methods to evaluate which capital projects they should pursue. Many companies start their evaluation process with the payback period method. However, before using this method, businesses should recognize its advantages and disadvantages.
Simple to Use
An advantage of using the payback method is its simplicity. The company determines the maximum number of years by which it wants the project to recoup the investment. The longer a project takes to recoup its cost, the higher the risk becomes of not recouping the cost at all. Companies typically prefer a shorter payback period to minimize the risk. The company divides the total cash outflow by the annual cash inflow to determine the number of years necessary to recoup the investment. If the calculated number of years exceeds the maximum, the company cancels the project.
Companies often need to decide among several projects. The payback method allows the company to screen projects -- another advantage of this system. First, the company determines its maximum payback period. The company eliminates any project whose cost would exceed the maximum payback period. As the company eliminates projects that don't pass the payback test, it focuses resources on the fewer, remaining projects. For example, if a company needs to choose between two projects, it may calculate the payback period for each project. For instance, if the company calculates a payback period of two years for the first project and five years for the second -- and if the company requires all projects to have a payback period of three years or less -- the company eliminates the second project and focuses its resources on the first project.
Time Value of Money
A disadvantage of the payback period is its disregard of money's fluctuating value. Inflation and deflation change the value of money over time. While some methods of evaluating capital projects -- like the net present-value method or the internal rate-of-return method -- allow businesses to consider the change in value over the project's life, the payback method does not. The company assumes all cash flow used to calculate the payback period occurs with no change in value.
Cash Flow After Payback
Another disadvantage of the payback method involves which cash flow the company considers in the calculation. When the company performs the payback-method calculation, it considers only cash flow that occurs until the project reaches its payback point. Any cash flow that occurs after this point makes no impact on the calculation.