Drawbacks of Payback Period

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En provenance du cours de Indian School of Business

Accounting and Finance for IT professionals

63 notes

Indian School of Business

Accounting and Finance for IT professionals

63 notes

Cours 3 sur 6 dans Specialization Business Technology Management

This course presents an introduction to the basics of financial accounting and finance for IT professionals. The first part of the course will focus on understanding the most important financial statements, namely, the balance sheet, the income statement, and the statement of cash flows. We will then focus on how we can understand the financial health and performance of the company by examining a number of important financial ratios that are derived from the financial statements of the company. The second part of the course will focus on the basics of finance. This includes the concept of time value of money, discounting cash flows, and capital budgeting. The course will also introduce the idea of real options, how they affect a project’s NPV, and their impact of the decision to accept/reject a project. Lectures on concepts will be supplemented with numerical examples.

À partir de la leçon

Capital Budgeting

In this series of videos, we will cover the various aspects related to deciding whether to accept or reject investment in a project. This starts off by discussing the common decision tools, namely, net present value (NPV), internal rate of return (IRR) and payback period (PBP) and how to calculate and interpret them. We will then move on to what free cash flows are and how to estimate them. Finally, we will focus on the flexibilities in projects, how to value them and how they affect the decision to accept or reject projects.

Net Present Value4:55

Internal Rate of Return and Payback Period5:41

Decide Between Two Projects6:31

Drawbacks of Payback Period4:05

Drawbacks of IRR and NPV6:29

Free Cash Flows7:22

Other Relevant Cash Flows4:18

A Capital Budgeting Example7:53

Sensitivity Analysis4:35

Uncertainties in Projects4:10

Resolving Uncertainties7:00

Rencontrer les enseignants

Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

[MUSIC]

While NPV, IRR, and payback period help managers decide on which projects to

accept or reject, they have their drawbacks.

In this video, we will discuss some of these drawbacks, and

discuss any possible fixes to these drawbacks.

We will start with drawbacks of payback period.

One drawback is that it ignores time value of money.

We have seen earlier in the course that cash flows occurring at

different points in time cannot be added, subtracted, or compared directly.

They need to be aligned at the same point in time through discounting or

compounding before they may be added, subtracted, or compared with each other.

This drawback of the payback period can be fixed using a discounted

payback period method.

Here we discount all cash flows back to today and

then we see how soon we recover the initial investment.

Let's revisit our earlier example of a project with an initial investment of

$1 million followed by annual cash flows of $200,000 for nine years.

We found its payback period to be five years.

The project had a discount rate of 15% per year.

The discounted payback period requires us to discount all cash flows back to 0.

The present value of the first year's $200,000 is 200,000 / 1 +

0.15 raised to the power of 1, which gives us 173,913.

Similarly, the present value of the second year's cash flow is

200,000 / 1 + 0.15 to the power of 2, which is 151,229.

We can similarly calculate the present values of each year's cash flows,

I'll let you do this.

Once we have the present values,

we can start adding the present values to the initial investment of $1 million.

We recover 173,193 in the first year, which means we're yet

to recover 1 million minus 173,913, which is 826,087.

We recover 151,229 in the second year, subtracting that from 826,087,

we have to recover 674,858 after the second year.

We continue doing this for every year and

we find that we still haven't recovered 45,683 at the end of nine years.

So while payback period showed that we recovered the initial investment

of 1 million in five years, discounted payback shows that we don't even recover

the initial investment at the end of the life of the project, after nine years.

So this project looks even less attractive once we use discounted payback period.

Another drawback of payback period is the threshold or acceptable value.

With NPV and IRR, there's an economic rationale for threshold value.

Positive NPV means that the project adds to shareholder wealth,

whereas a negative value reduces shareholder wealth.

An IRR greater than the hurdle rate,

shows that the project returns more than the cost of capital.

While an IRR less than the hurdle rate,

says that the project returns less than the cost of capital.

However, there is no economic rationale for

what is an acceptable payback period and what is not.

We may say that a project is acceptable if its payback period is three years or less.

But why is a project with a payback period of greater than three years not

acceptable?

So payback period may be based on arbitrary decisions.

A third drawback of payback period is that it ignores cash flows

once the initial investment is recovered.

This is especially problematic if the project requires additional investment or

has large losses later in its life.

We may accept a project with a short payback period even though the large

negative cash flows later in the project's life make it unattractive.

Despite all these drawbacks, managers still use payback period

to decide which projects to accept and which ones to reject.

It still provides an easy way to determine how quickly a manager can

recover the initial investment.

Next time, we will discuss drawbacks of using IRR and NPV as decision tools.

And look at possible fixes to these drawbacks.

[MUSIC]

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