payback period method
payback period method A method of capital budgeting in which the time required before the projected cash inflows for a project equal the investment expenditure is calculated; this time is compared to a required payback period to determine whether or not the project should be considered for approval. If the projected cash inflows are constant annual sums, after an initial capital investment the following formula may be used:
Otherwise, the annual cash inflows are accumulated and the year determined when the cumulative inflows equal the investment expenditure. The method is sometimes seen as a measure of the risk involved in the project.
The two major weaknesses of the payback method are:
However, payback is a relatively simple technique for managers to use and for this reason it remains popular. Often managers use payback and discounted cash flow techniques at the same time, even though they are very different methods of capital budgeting (seediscounted payback method).
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