Course Outline
Join PRO

What are the limitations of the payback period?

Author:
Harold Averkamp, CPA, MBA

Definition of Payback Period

The payback period is a common (but not the best) tool for screening a company’s potential investments. It uses the potential investment’s undiscounted cash flows to calculate the number of years it will take for the company to recoup its investment.

Example of Payback Period

Assume a company invests $100,000 in a project that is expected to have the following positive net cash inflows:

  • $30,000 in Year 1
  • $40,000 in Year 2
  • $40,000 in Year 3
  • $50,000 in Year 4

The payback period for the $100,000 investment is approximately 2.75 years ($30,000 + $40,000 + $30,000 of Year 3’s $40,000).

Limitations of Payback Period

The payback period has two limitations or drawbacks:

  • The net cash inflows are typically not adjusted for the time value of money. This means that a net cash inflow of $50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a $50,000 cash outflow that was part of the initial investment made four years earlier.
  • The cash flows received after the payback period are ignored.

Example of Limitations of Payback Period

Assume a corporation is considering investing in one of two projects:

  • Project #187 has a payback period of 4 years. However, the amounts of the net cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7
  • Project #188 has a payback period of 6 years. However, the amounts of its net cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15

While Project #187’s payback period is faster, Project #188 is significantly more profitable. Hence, the limitation of using only the payback period when ranking potential investments.

Join PRO to Track Progress
Must-Watch Video

Advance Your Accounting and Bookkeeping Career

  • Perform better at your job
  • Get hired for a new position
  • Understand your small business
  • Pass your accounting class
Watch the Video

Join PRO or PRO Plus and Get Lifetime Access to Our Premium Materials

Read all 2,645 reviews

Features

PRO

PRO Plus

Features
Lifetime Access (One-Time Fee)
Explanations
Quizzes
Q&A
Word Scrambles
Crosswords
Bookkeeping Video Training
Financial Statements Video Training
Flashcards
Visual Tutorials
Quick Tests
Quick Tests with Coaching
Cheat Sheets
Business Forms
All PDF Files
Progress Tracking
Earn Badges and Points
Certificate - Debits and Credits
Certificate - Adjusting Entries
Certificate - Financial Statements
Certificate - Balance Sheet
Certificate - Income Statement
Certificate - Cash Flow Statement
Certificate - Working Capital
Certificate - Financial Ratios
Certificate - Bank Reconciliation
Certificate - Payroll Accounting

About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

Certificates of
Achievement

Certificates of Achievement

We now offer 10 Certificates of Achievement for Introductory Accounting and Bookkeeping:

  • Debits and Credits
  • Adjusting Entries
  • Financial Statements
  • Balance Sheet
  • Income Statement
  • Cash Flow Statement
  • Working Capital and Liquidity
  • Financial Ratios
  • Bank Reconciliation
  • Payroll Accounting
Badges and Points
  • Work towards and earn 30 badges
  • Earn points as you work towards completing our course
View PRO Plus Features
Course Outline
Take the Tour Join Pro Upgrade to Pro Plus