FAQ's
What are the limitations of the payback method?
Payback period in business and economics refers to the time required for the return on an investment to "repay" the sum of the original investment. For example, a $1,000 investment which returned $500 per year would have a two year simple payback period. It measures how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods (all else being equal). It also implicitly assumes that benefits from the investment continue after payback is achieved, thus leaving the investor with continued net benefits.(abstracted from Wikipedia)
The simple payback period method has some significant limitations and qualifications for its use, because it does not account for the time value of money, risk, financing or other important considerations such as the opportunity cost (what else you would be doing with your money). As well, payback period does not specify any required comparison to other investments or even to not making an investment.
Another serious drawback of the payback method is that it instills a mindset of “quicker the better” rather than a mindset of what is the best long term investment (below).
** Time value of money - What the future value of an investment is, in today’s dollars, taking into account the costs of capital or perhaps the value that could reasonably be achieved from another investment.
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