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Pay-Back Method: Merits and Demerits | Capital Budgeting

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Let us make an in-depth study of the merits and demerits of pay-back method.

Merits of Pay-Back Method:

The merits or advantages of Pay-back methods!

(1) This method is Easy and Simple:

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Pay-back method is easy to calculate and simple to understand. Its quick computation makes it a favourable among executives who prefer snap answers.

(2) Ranking of Projects:

This method is preferred by executives who like snap answers for the selection of the proposal. The projects are ranked in terms of their economic merits without much complications.

(3) It Stresses the Liquidity Objective:

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Because this method gives importance to the speedy recovery of investment in capital assets.

(4) Useful in Case of Uncertainty:

Pay-back method is useful in the industries which are subject to uncertainty, instability or rapid technological changes because the future uncertain­ty does not permit projection of annual cash inflows beyond a limited period. It reduces the possibility of loss through obsolescence.

(5) Handy Device or Method:

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This method is handy device for evaluating investment proposals where procession in estimates of profitability is not important.

Demerits or Limitations of Pay-Back Method:

Important de-merits of Pay Back Methods are as follows:

(a) It ignores annual cash flow:

Pay-back method totally ignores the annual cash inflow after the pay-back period.

(b) It considers only the period of pay-back:

Pay-back method does not consider the pattern of cash inflows or the magnitude and timing of cash inflows.

(c) It overlooks capital cost:

Pay-back method overlook the costs of capital i.e., interest factor which is an important consideration in making sound investment decisions.

(d) No rational basis of decision:

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There is no rational basis for determining the minimum acceptable pay-back period. It is generally subjective decision of the management which creates so many administrative difficulties.

(e) It is delicate and rigid:

A slight change in operation cost may affect the cash inflow and as such pay-back period shall not be affected.

(f) This method over emphasises the importance of liquidity as a goal of capital expenditure decisions:

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However, in-spite of these drawbacks we cannot undermine the importance and popularity of this method. This is more popular in America and in England.

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