Capital budgeting involves the financial planning needed for companies to expand and grow. This type of planning enables companies to leverage existing and future cash flows while reaping the best possible profits. As one of many methods of capital budgeting, the payback approach helps companies identify rates of return on an investment or project. The strengths and weaknesses of the payback approach can vary depending on the types of projects under consideration.
Companies considering expansion projects, research and development plans or new product line offerings use capital budgeting as a way to compare the costs and benefits of different project options. Companies invest large amounts of cash for long periods of time, so project selection becomes a priority. Different capital budgeting methods use different criteria for determining the strengths and weaknesses of each project. One company may wish to know each project’s profit earnings capacity while another focuses on each project’s overall costs versus revenues. Companies concerned with recouping the monies invested in a project may opt to use the payback period approach in their capital budgeting process.
Payback Period Approach
With any project investment, companies attempt to maximize their return on investment in one way or another. For some companies, recouping their initial cost in as short a time as possible provides the maximizing effect needed. The payback period approach enables a company to calculate the length of time it will take before a project generates as much money as it costs. When comparing two or more project options, the length of time it takes each project to pay for itself becomes the determining factor in project selection when companies use the payback period approach. In other words, the faster a project can recoup its initial investment cost the more likely a company will consider investing in it.
The payback approach may offer advantages in cases where a company has certain time requirements in terms of how long a project will take to pay for itself. Because of its focus on cost returns, companies can use the payback approach as an initial screening tool when comparing two or more project options. Knowing how long an investment will take to pay for itself also comes in handy in cases where project investments tie up large amounts of money for long time periods. For companies just starting, a need for cash flow may require a project to generate a fast return on investment. The payback approach helps identify which projects offer the quickest payback period.
Because different capital budgeting methods emphasize different aspects of a project investment, the weaknesses in the payback approach result from its focus on the payback period. Other important factors to consider in project selection involve a project’s profit earnings capacity, overall return on investment and time period comparisons. Projects that require a long payback period may actually generate larger returns than a project with a short payback period. The payback approach provides little to no information regarding the rates of return when comparing two or more project options, meaning one project may generate increasing returns after a longer period of time. In effect, the payback approach leaves out information regarding profitability during project payback periods as well as any profits made after payback periods end.