Short note: advantages of payback period

The payback period is the time needed for the net cash inflows of a project to recover the initial investment. Simple payback = I / annual net inflow (for uniform inflows); for uneven inflows, add the cumulative inflows until they equal I. A project is accepted if its payback is less than the maximum acceptable period.

Advantages

1. Simple and fast. Easy to calculate and to understand, even without much financial training.
2. Measures liquidity. It shows how soon the invested money comes back, important when cash is scarce.
3. Handles risk and uncertainty. A short payback means less exposure to future uncertainty, obsolescence and political or market change. It is useful for risky or fast-changing industries (electronics, software).
4. Quick screening tool. Many proposals can be ranked and rejected rapidly before a detailed analysis (PW, IRR).
5. Needs little data. Only the investment and the annual net inflows are needed; no MARR or exact project life is required (for the simple form).
6. Favours early cash flows, which are more certain than distant ones.
7. Discounted payback also accounts for the time value of money while keeping these benefits.

Limitation to keep in mind

It ignores cash flows after the payback period and, in the simple form, the time value of money, so it should support, not replace, PW or IRR analysis.

Example: a Rs 6,00,000 machine with net saving of Rs 2,00,000 per year has payback 3 years.