The payback method does not specify any required comparison to other investments or even to not making an investment the payback period is usually expressed in years start by calculating net cash flow for each year: net cash flow year one = cash inflow year one – cash outflow year one. Since the machine will last three years, in this case the payback period is less than the life of the project what you don’t know is how much of a total return it will give you over those three years this is the major limitation of the payback method as knight says, “it doesn’t tell you much. Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions a variation of payback method that attempts to remove this drawback is called discounted payback period method.
The net present value method and payback period method or ways to appraise the value of an investment under npv, a project with a positive value is worth pursuing with the payback period method, a project that can pay back its launch costs within a set time period is a good investment. Payback method | payback period formula july 29, 2017 / steven bragg the payback period is the time required for the amount invested in an asset to be repaid by the net cash flow generated by the asset.
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. The payback period disregards the time value of money simply, it is determined by counting the number of years it takes to recover the funds invested for example, if it takes five years to recover the cost of the investment, the payback period is five years some analysts favor the payback method for its simplicity.
What mistakes do people make when using the payback method one of the fundamental flaws in the method is you’re not taking into account the time value of money, translating future cash flows.