IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 6. What is a payback and what is its importance?

Ans. PAYBACK PERIOD

The Payback- period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR. Ordinary people not well versed in appraisal techniques, often use very simple technique to judge the profitability of any investment proposal. They think in terms of initial expenditure (outflow) and the time duration in which this amount can be recovered. Suppose somebody spent Rs.50,000 on any project and expects that within 3 year he can get back this amount, then the payback period is 3 years. Payback period of any proposal can be calculated as follows;

 If the cash inflows are uniform then

Payback period = Initial cash outflow / Annual cash inflows

If the cash inflows are not uniform then

Payback period = time period in which the cumulative cash flows are equal to initial inflows.

Acceptance Rule and Ranking Rule : - If the calculated payback is less than any predicted value then an investment proposal is acceptable, otherwise it will be rejected. So far as ranking is concerned, the lower the value of the payback the higher will be the ranking of any investment proposal.

Evaluation of payback method :- It is a simple method in concept and understanding. That is why even lay men can understand and use it with ease. Moreover, since its emphasis is on early recovery of investment, it automatically takes care of risk. Projects with smaller payback are considered safer and secure as compared to the projects with longer payback.

The payback method, however, suffers from serious drawbacks. Firstly it takes into account only early cash flows which determine the payback and ignores those which come later. This may be often leading to wrong conclusions.