The payback method has been criticized by financial experts and academicians as unsophisticated and theoretically incorrect because it ignores the time value of money, ignores cash flows beyond the payback period, and is inconsistent with the owner’s goal of maximizing wealth. In small and large firms, where the payback method has been used, it has been found that it has unique properties which are not shared by other frequently used criteria, namely net present value, internal rate of return, and accounting rate of return. In addition, the minimum required payback for an accept/reject decision is a subjectively determined number.
The principal weakness of the payback method is that it ignores what happens after the payback period. When the total cash flow for a particular project is far higher than the cash received from any of the projects, it can still be rejected on the basis that this project does not recover the initial investment within the stipulated payback period. Consider two projects that are equally attractive. Project one provides $1 in 2004 and then $399 in 2005. Project two generates $399 in 2004 and only $1 in 2005.
The payback method would hold that these two projects are equally attractive. In reality, the extra $398 received in 2004 from Project two can be reinvested in other profitable opportunities for one year, and hence it is clearly superior to Project one. The problem is that the payback method does not formally take into account the time value of money. Due to these limitations, the payback method cannot be recommended as the main method used by a company to assess potential investment projects.
