Learn On Your Own Accounting Entries For Payback Period:

Payback period, also called PBP, is the period of time required for an investment's to recoup its initial cost of investment.

In other words, it is the methodical procedure of analyzing an investment opportunity based upon the time period required to pay back its investment cost. The length of the period required is the decisive factor in an investment period. The longer the payback period, the risky the investment might be is the theory followed. From the management point of view, the shorter the investment period, the better it is as because the company can get back its money reinvestment it in equipment or project.

Formula Of Payback Period:

The formula for payback period is very simple:

Payback Period =Initial Investment
Net Cash Inflow per Period

According to this method, a project is considered desirable if it promises a quick recovery of initial investment.

From the above formula, the project's decision will be accepted only if the payback period is shorter than or equal to the management's maximum desired payback period.

Advantages Of Payback Method:
  1. Simple to compute and easy to understand
  2. Provides some information on the risk of the investment
  3. Provides a crude measure of liquidity
  4. It is more useful for those industries where investments become obsolete very quickly
Disdvantages Of Payback Method:
  1. It ignores the life span of a machine.
  2. It neglects the additional cash flow that an investment may generate after its payback period.
  3. The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all
  4. No concrete decision criteria to indicate whether an investment increases the firm's value
  5. The method does not consider the time value of money where in later period more cash can be earned with less work.
  6. Ignores the risk of future cash flows.