What are the drawbacks of using the payback period method for evaluating capital projects?

1 Ignoring time value of money

One of the biggest drawbacks of the payback period method is that it ignores the time value of money, which is the principle that money today is worth more than money in the future, due to inflation, interest rates, and opportunity costs. This means that the payback period method does not account for the risk and return of a project, and does not discount the future cash flows to their present value. As a result, the payback period method can overestimate the attractiveness of a project that has a short payback period but low cash flows in the later years, and underestimate the value of a project that has a longer payback period but higher cash flows in the future.

2 Lacking a clear decision rule

Another drawback of the payback period method is that it lacks a clear and consistent decision rule for accepting or rejecting a project. Unlike other methods, such as the net present value (NPV) or the internal rate of return (IRR), which have a specific threshold or criterion for choosing a project, the payback period method depends on the arbitrary choice of a maximum acceptable payback period by the decision maker. This can vary depending on the preferences, expectations, and objectives of different managers, investors, or stakeholders, and can lead to inconsistent and subjective decisions. Moreover, the payback period method does not indicate how much value a project adds to the firm, or how it compares to other mutually exclusive projects.

3 Excluding cash flows after payback

A third drawback of the payback period method is that it excludes the cash flows that occur after the payback period, which can be significant for some projects. For example, a project that has a high initial investment but generates substantial cash flows for many years after the payback period will have a low payback period value, but a high NPV or IRR value. Conversely, a project that has a low initial investment but produces negligible cash flows after the payback period will have a high payback period value, but a low NPV or IRR value. Therefore, the payback period method can bias the decision maker towards short-term projects that have quick returns, but ignore the long-term profitability and sustainability of a project.

4 Failing to consider risk and uncertainty

A fourth drawback of the payback period method is that it fails to consider the risk and uncertainty of the cash flows of a project, which can vary depending on the market conditions, competition, technology, regulation, and other factors. The payback period method assumes that the cash flows are certain and constant, and does not adjust them for the probability or variability of their occurrence. This can make the payback period method unreliable and inaccurate, as it does not reflect the true risk-adjusted value of a project. Furthermore, the payback period method does not incorporate any flexibility or optionality in the decision making process, such as the ability to delay, expand, or abandon a project, which can affect the value and feasibility of a project.

5 Neglecting non-financial factors

A fifth drawback of the payback period method is that it neglects the non-financial factors that can influence the evaluation and selection of a project, such as the strategic, social, environmental, ethical, or reputational implications. The payback period method focuses only on the cash flows and the payback period of a project, and does not account for the qualitative aspects that can affect the performance and desirability of a project. For example, a project that has a long payback period but contributes to the innovation, customer satisfaction, or competitive advantage of a firm may be more valuable than a project that has a short payback period but harms the environment, the community, or the brand image of a firm. Therefore, the payback period method can overlook the intangible benefits or costs of a project, and fail to align with the vision, mission, and values of a firm.