Usually, companies determine a standard payback time period, for projects “such as two years or two quarters” when screening potential investments (Sehlhorst 2006). One justification for such hard and fast rules is that the longer the investment takes to pay back given the expected firm profits, the more likely the capital expended upon the investment could have been better used on something else, including more innovative and potentially less expensive technology and other market opportunities that could have paid back more quickly. And “the payback period relies on the assessment of a companys earnings potential. It is harder to predict such potential further into the future, and subsequently there is a greater risk that those returns will not occur” (PEG payback, 2010, Answers.com). Thus short-term return investment predictions are more likely to be accurate. Few economists, for example, predicted the extent of the recent credit crisis and market meltdown. Payback duration can also be evaluated in terms of the collective body of investments made by a firm. A large amount of investments that can only pay back over the long-term could threaten a firms financial health, if market conditions rapidly change. This level of risk is especially true for a small, young organization that has a statistically higher probability of failure during its first years.
However, payback has additional disadvantages in terms of its potentially pessimistic outlook for long-term investments: it does not, for example, calculate the future profitability of a firm. The cautious view of the future encouraged by a simple payback-driven perspective can result in focusing on short-term rather than long-term prospects. “It is a reality that some companies (or project sponsors) choose the less-profitable investment if they get their money back faster.
The most common reasons for this decision would be if a private company is strapped for cash, and does not want to use debt to finance operations. Public companies can also be faced with this situation, if they find that market valuations are predominantly driven by cash flow instead of profitability. A bootstrapped start-up company may also be forced to make short-term investment decisions based upon cash flow” (Sehlhorst 2006). Not only is this bad for the start-ups individual stability and future growth, but in the overall market environment a profit-driven payoff focus discourages all companies from making investments in projects that could pay off in the very long-term and bring financial health to shareholders and real value to consumers. The focus shifts to making money on paper.
Payback has begun to fall out of favor and even most financial risk assessors say that their firms only recommend using payback analysis when a small firm is “cash-strapped (with an aversion to debt-financing), or as a tie-breaker against apparently equivalent projects (based upon ROI)” (Sehlhorst 2006). The information it provides about risk is relatively limited and narrow, and a more comprehensive picture about the general market environment and the specifics of the project are required to engage in meaningful risk analysis.
Payback period. (2010). Accounting Dictionary. Retrieved July 13, 2010 at http://www.allbusiness.com/glossaries/payback-period/4946012-1.html
Payback period. (2010). Q-Finance. . Retrieved July 13, 2010 at http://www.qfinance.com/dictionary/payback-period
PEG Payback period. (2010). Answers.com. Retrieved July.