Payback Method

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Payback Method

The payback method is useful because of its simplicity. You simply take the expected cash inflows per year expected after the initial investment and find the breakeven point in where the cash inflows equals the initial investment. Whenever that breakeven point occurs on your timeline, that is your payback period. Let us suppose an initial investment for a project is $1.3 million, the expected cash inflows for the first two years totals $850,000, and the third year is expected to be $475,000. $850,000 subtracted from $1.3 million equals $450,000 left, which needs to be taken out of the $475,000 to derive at the breakeven point. 450 divided by 475 is 0.95. When this is taken and added it to the first two years, it is easy to see that the payback period is 2.95 years. (Gitman, 2009, p. 426)

The payback method is a one-sidedly derived number which tells a small amount about a project's beginning phase, but it tells one close to nothing about the full lifetime of the project. The effortlessness of calculating payback can possibly promote carelessness, especially in the failure to incorporate all the costs linked with investing in a project, such as training and maintenance. The payback method does not account for the time value of money either, and is therefore considered an unsophisticated capital budgeting technique. Even though the payback method has these cons associated with it, the simplicity of the method can allow it to be used as a filter for those projects which should go on to a more in-depth method, such as those explained below. If a project is not recommended based on the payback method, then chances are pretty high the project should not even be considered for the other

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