What is the major criticism of the Payback Period Method of Capital Budgeting?

Pay back period method is one of the commonly used techniques of evaluating capital expenditure proposals. It is a cash based technique. Pay back period is the length of time or period required to recover the initial cost of the project. It is the expected number of years during which the original investment is recovered. It is the break even point of the project where the accumulated returns equal investment. Pay back method is also called pay out or pay off period or replacement or recoupment period.

When annual cash inflows are equal, pay back period is calculated by;

Pay back period = Original cost of the project/ Annual net cash inflows

When annual cash inflows are unequal;

Pay back period = E+(B/ C)

E = Number of years immediately proceeding the year of final recovery

B= Balance amount still to be recovered

C= Cash inflow during the year of final recovery

Under pay back method, the cash inflow means the operating profit before depreciation and amortization of intangible assets but after tax. According to pay back criterion, the shorter the pay back, the better the project. This means a project having shorter pay back period is chosen.

Major criticism of pay back period

1. It ignores the time value of money.

2. It completely ignores the cash inflow after the pay back period .

3. Sometimes a project having higher pay back period may be better than lower pay back period owing to higher return after pay back period. This is true in the case of long term projects.

4. It does not measure profitability of projects. It insists only on recovery of the cost of the project.

5. It does not measure the rate of return.

These are the major criticism of pay back period method of capital budgeting.