Wealth management professional or finance professionals always suggest businesses to evaluate the profitability or desirability of an investment project. This is usually undertaken by using quantitative techniques that assess the financial feasibility of the project. Multiple techniques are used to evaluate the results of an investment. There are different techniques and one of the most common techniques is investment appraisal technique which involves the payback period time.
The decision to invest in the business involves a high degree of risk. There may be the considerable choice of projects from which the business can choose from. If the costs and revenue data is accurate or the budgeted figures are always correct, then almost all the businesses in the world would survive without any difficulty. Investment decisions mostly fail because they are based on uncertainty. Investment is also considered to be risky as it is funded by borrowed money. And this would involve the cost of borrowing as well. So if the business falls, the business will have to repay the loans borrowed from the banks.
The decision to make an investment or not can be taken by the calculation of the payback period. The payback period is the length of time it takes for the business to recover its investment. It is important to take payback into consideration when making investment decisions as a long payback period will increase the interest payments. The speeder the payback, the quicker the capital is made available for other projects. A payback period more than 50% of the useful life would be a negative indicator. Payback is easy to calculate. It is particularly useful for businesses where liquidity is of greater significance than overall profitability. The emphasis on the speed of return of cash flows gives the benefit of concentrating on more accurate short-term forecasts of the project’s profitability.
However, payback does not measure the overall profitability of the project and does not take into account cash flows after the payback period. The concentration on the short term return may lead the business to reject very profitable projects only because they take time to repay the capital.