The payback period is expressed in years and fractions of years. For example, if a company invests $300,000 in a new production line, and the production line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback).

How does the payback method work?

The payback method simply projects incoming cash flows from a given project and identifies the break even point between profit and paying back invested money for a given process. However, the payback method does not take into account the time value of money.

What are the two drawbacks associated with the payback period?

Disadvantages of the Payback Method Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years.

How do you calculate payback period with different cash flows?

There are two ways to calculate the payback period, which are:

1. Averaging method. Divide the annualized expected cash inflows into the expected initial expenditure for the asset.
2. Subtraction method. Subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved.

Why is the payback period often criticized?

The payback period is often criticized lack of the concept of time value of money. Under the assumption of constant future cash flows, the payback period is equal to the present value interest factor of annuity (PVIFA).

What are the drawbacks in payback period method?

Disadvantages

• It doesn’t take Time Value of Money into consideration. This method doesn’t consider the fact that a dollar today is way more valuable than a dollar promised in the future.
• The method additionally doesn’t take into consideration the inflow of cash after the payback period.