Using PBP method a company will accept all those ventures whose payback period is less than that set by the management and will reject all those ventures whose PBP is more than that set by the management. Alternatively, PBP may be gauged against the term of the loan in which case the PBP method will give a high ranking to all those ventures paying back before the term of the loan and the highest ranking will be given to those projects with shortest PBP. However, in assessing the viability of a venture it is also important to see which venture brings returns earlier, other things being equal.
Advantages of Payback Period
1. Simple to use and understand and this has made it popular among executives especially traditional financial managers in ascertaining the viability of a venture.
2. Ideal under high-risk investments because it will identify which venture will payback earlier thus minimising the risks with a venture.
3. Advantageous when choosing between mutually exclusive projects because it will give a clue as to which venture is viable if one considers the shortest PBP and the highest inflow of a venture.
Disadvantages of Payback Period
1. Does not take into account time value of money and assumes that a shilling received in the 1st year and in the Nth year have the same value so as to rank them together to ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now.
2. PBP method does not measure the profitability of a venture but rather measures the period of time a venture takes to pay back the cost. The method is outside looking (lender oriented rather than owner oriented).
3. PBP method ignores inflows after PBP and as such, it does not accommodate the element of return to an investment.
4. This method will not have any impact on the company’s share prices because profitability which is one of the most important factors in gauging the company’s value of shares is not a function of PBP and as such the method fall short of meeting the criteria of investment appraisal.