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The payback method is one of the most popular tools in conducting capital budgeting decision. The payback period tells the company the length of time required to recoup the original investment through investment cash flows. This is essentially the time when the company breaks even-the initial capital outlay is equal to the cash flows.
There are essentially three reasons why the payback method is popular among business circles. First of all, the payback method is simple. The computation is less complicated and is easily grasped by managers. The payback method is "easy to compute and easy to understand." Secondly, the payback method is gives some indication of risk. As this technique indicates the length of time that the investment can be recouped, it gives the company an opportunity to separate long-term projects to short-term ones. This also makes the payback method a good screening tool for prospective projects and alternatives. Lastly, this tool helps the company gain a more accurate and reliable assessment of a project by taking into account taxes and depreciation (Lightfoot 2003). It should be noted that the in the computation of cash inflow from operation, the aforementioned expenses are not overlooked.
However, the use of the pay back period in assessing the profitability of an investment also suffers limitation. There have been a lot of criticisms on the efficiency of this method as a capital-budgeting tool. The payback method is not a reliable method of profitability because it stresses the return of investment and not on the return on investment. ...
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