Question

What are the Problems associated with the Payback Methodology? Why do people use this, then?

Answer 1

The two major problems associated with the payback methodology are as follows:-

(1) It does not consider time value of money while evaluating whether we should accept the project or not .However the modified payback period overcomes this limitation

(2)It does not consider cash flows beyond payback period i.e, It does not consider all the cash flows of the project .For example there is a 5 year project and the payback period is 3 years then cash flow in year 4 and 5 is of no use in this methodology.

But still people use this methodology because of the following reasons :-

(1) This method is very simple to use.It does not require much time and effort and sophisticated economic analysis.

(2)It is often used by people when the investment is small i.e, the project is not so large .It tells us,how much time the project will take to recover initial investment using annual cash inflows.