The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of $100,000 is made and it generates cash of $50,000 for two years followed by $10,000 per year for four additional years, its payback is two years ($50,000 + $50,000). If another investment of $100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000 per year for six additional years, its payback is approximately 3.5 years ($20,000 + $20,000 + $40,000 + 0.5 times $40,000).
As you can see in the examples, payback only answers one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only ignored the time value of money, it ignored all of the cash received after the payback period.
The accounting rate of return or return on investment (ROI) are two more examples of methods used in capital budgeting that does not involve discounting future cash amounts.
To overcome the shortcomings of payback, accounting rate of return, and return on investment, capital budgeting should include techniques that consider the time value of money. Two of these methods include (1) the net present value method, and (2) the internal rate of return calculation. Under these techniques, the future cash flows are discounted. This means that each dollar in the distant future will be less valuable than each dollar in the near future, and both of these will have less value than each dollar invested in the present.
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