The pay hack method has certain merits. It is’ easy to calculate and simple to understand. Moreover, the pay back method is an improvement over the ARR approach. Its superiority arises due to the fact that ir is based on cash now analysis. The ‘results of Example 10.6 illustrated in Table 10.10 can be cited in support of this. Thus, though the average cash flows for both the machines under the ARR method were. the same. the pay back method shows that the pay back period for machine B is shorter than for machine A. The pay back period approach shows that-machine II should be preferred as it refunds the capital outlay earlier than machine A. The pay back approach however suffers from serious limitations. Its major shortcomings are as follows:
Tile first major -shortening of the pay hack ll 11’ thud is thou it completely ignore all cash inflows after the pay hack period. This can be very mill aiding in capital budgeting evaluations. Table 10.8 reveals alternative projects with the same pay (5 years).
In fact, the projects differs widely in respect of cash inflows generated after the pay back period. The cash flow for project X stops at the end of the third year, while that of Y continues up to the sixth year. Obviously the firm would prefer project Y because it makes available to the firm cash inflows of Rs I 2,000, in years 4 through 6, whereas project X does not yield any cash inflow after the third year. Under the pay back method, however, both the projects.would be given equal ranking, which is apparently incorrect. Therefore cannot be regarded as a measure of profitability. Its failure lies in the fact that it does not consider the total benefits accruing from the project
Another deficiency of the payback method is that it does not measure correctly even the cash tows expected to be rec•.i.v. ed within the pay back period 3 S it docs not differentiate between project’ in terms of the timing or the magnitude of cash flows. It considers only the recovery period as a whole. This happens because it does not discount the future cash inflows but rather trues a rupee received in the second. or third year as valuable as a rupee received in the first year. Rhino words, to the extent the pay back method fails to consider the pattern of cash inflows, it ignores the time value of money. Table 10.9 shows that both the projects A and B have (i) the same cash outlays in the zero time period. (ii) the same total cash inflows of Rs 15,000;.and (iii) the same pay back. period of 3 years. But project A would be acceptable to the firm because it returns cash earlier than project B, enabling A to repay a loan or reinvest it and earn a return. A possible solution to this problem is provided by determining the pay back period of discounted cash flows, This is illustrated in the subsequent section of this chapter
Another flaw of the pay back .method is that :1 does not take into consideration the entire life of the project during which cash flows are generated. As a result, projects with large cash inflows in the latter pan of their lives may be rejected in favor of less profitable projects which happen to generate a larger proportion of their cash inflows in the ‘earlier pan of their” lives. Table 10.10 presents the comparison of two such projects. On the basis of the pay back criterion, project ,A be adjudged superior to project B.
It is quite evident just from a casual inspection that project B is more profitable than project A, since the cash inflows or the former amount to Rs 4′;,000. after the expiry or the pay back period and the cash flows or the latter beyond the pay back period are only Rs 7,000. The above weaknesses notwithstanding, the pay back method can be gainfully employed under certain circumstance? in the first place, where the long-term outlook, say in excess of three years. is extremely hazy, the pay back method may be useful. In a politically unstable country, for instance, a quick return to recover the investment is the primary goal, and subsequent profits are almost unexpected surprises. likewise, this method may be very appropriate for firms suffering from liquidity crisis.A firm with limited liquid assets and no ability to r.li~ additional funds. which nevertheless wishes to undertake capital projects in the hope of easing the’ crisis, might use Pay back as a selection criterion because it overemphasis quick recovery of the firm’s original outlay and Lillie impairment of the already critical liquidity situation. Thirdly, the pay back method may also be beneficial in taking capital budgeting decisions for firms which lay more emphasis on short-run earning performance rather than its long-term growth, The pay. back period i~ a .I 11 assure of liquidity or investments rather than their profitability, TI1US, the pay back period should more appropriately he treated as a constraint to be satisfied than as a profitability measure to be maximized+’ Finally, the pay back period is useful, span from measuring liquidity, in making calculations in certain situations.
For instance, the internal rate of return can be computed easily from the pay back period, The pay back method is a good approximation of the internal rate or return which otherwise requires a trial and. error approach.
To conclude the discussion or the traditional methods of appraising capital investment decisions, there are !WO major drawbacks of these techniques. They do not consider the total benefits in terms of (j) the magnitude and (ii) the timing of cash flows. For these reasons.the traditional methods are unsatisfactory as capital budgeting decision criteria. The TWO essential ingredients of a theoretically sound appraisal method, therefore, are that (i) it should be based on a consideration of the total c~sh stream, and (ii) it should consider the time value of money ;IS reflected in both the magnitude and the timing of expected cash flows in each period of a project’s life, The time adjusted (also known as discounted cash now) techniques satisfy these requirements and, to that
extent, provide a more. objective basis for selecting and evaluating investment projects