Companies and managers often have to decide between various projects. They use different methods to choose the right project to benefit their business. While the managers may sometimes make decisions based on the overall production, they may also consider aspects like the return on investment. One of them is the payment period approach. The payback approach lies in the payback period of an investment. Let us tell you about the advantages of the payback period in the project. You can read about the disadvantages in another article here.
What is the Payback Method?
The payback method helps understand the payback period of investment. It refers to the number of years it would take for the return from a specific project to cover the initial investment. Most business owners and managers will be more inclined towards a project with a shorter payback period to recover their amount in the shortest period. Let’s say two projects cost the same. One of them gives a higher annual return than the other. The company is more likely to opt for the one with a higher yearly return as it means a shorter payback period.
Advantages of the Payback Period in Project
Selecting a project based on the payback period has advantages and disadvantages. Here are all the benefits of the payback period.
The payback period method is one of the simplest processes in projects. You can easily access the best choice out of different projects depending on the payback period offered by the company. Often managers opt for this method when they cannot decide on the right investment option. You can make a better decision without thinking much about the intricacies of the project.
Comparing two projects for the payback method is easier than other methods. You do not have to calculate a lot to make the decision. You will only have to find out the monthly or yearly returns from each investment. It will enable you to make a suitable decision with easy numbers. It may not give detailed prospects about all variables, but it is a convenient way to make a basic comparison.
The best part about opting for the payback period approach for projects is that it allows you to reinvest your earnings faster.
You can make the right investment choices by trying it yourself. When you choose a shorter payback period, you get the returns early and can reinvest those in another project. You can decide if you want to invest in the same project again or choose another one that gives even better returns in a shorter period.
Good choice for Small Businesses
Small businesses usually do not have huge investment capital and take risks to bear losses. Thus, it is a better choice for small businesses to use the payback period approach. It is suitable for small businesses and offers the same kind of benefits to large enterprises. However, as a small business, you can use this method to see which project will give returns in the shortest period.
The payback period is a more reliable method of project selection as it allows you to get your returns at the earliest. It keeps you safe from fraud and potential damage to the business. You may work with a new business as well without having to wait for the cash flow for a long time.
Investing your capital in long-term projects may deprive you of better investment opportunities. When you get your investment back in less time, you can use the liquid capital soon in any project. It is one of the most significant payback period methods advantages. It gives you financial liquidity and ensures you can utilize your money when needed. It also gives you the liberty to have money in hand to use in case of trouble.
When you invest in a new project for the long term, you may not be sure about its values and return protocols. As small and medium-sized businesses are usually under financial constraints, you can opt for a short payback period in the project. However, if you invest in a company that gives you returns over a short period, you will have a shorter time to break even and reduce the risk of loss.
Useful in Uncertainties
The payback period method is useful in businesses that experience rapid technological changes and are prone to modifications. These uncertainties make it difficult for small businesses to predict the future of their investments. The payback method gives short-term forecasts and early returns to reduce losses.
The Bottom Line
The payback period is one of the most popular methods for project selection. It is a simple approach that helps you make decisions without crunching several numbers. The payback method ensures financial liquidity and gives you early returns. You can reinvest the returns sooner than long-term investments. It is a better choice for medium and small businesses as it is more reliable. This method is also a preferred choice in industries with unpredictable changes.
How is the Payback Period Useful to Appraise the Project?
The payback period is a convenient method to decide on the project as it allows you to calculate the risks easily. You can compare two or more projects based on their returns and see which one seems the less risky for you. It can be an excellent choice if you want to make quick decisions.
What are the Advantages and Disadvantages of Discounted Payback Period?
The discounted payback period is quite attractive when investing. Yet, you must consider other aspects of the strategy when opting for it. This approach may ignore the cash flow after the payback period. Thus, make sure to consider the useful payback period and decide accordingly.
What is the Importance of Payback Period?
The payback period is utilized by managers, business owners, financial professionals, and investors when investing in a project. It gives an easy estimate of the payback period and facilitates the decision-makers to make the right choice.
Matthew is a Co-Founder at BusinessFinanceArticles.org. Matthew was a floor manager at a local restaurant in Wales. He lost his job after the pandemic and took initiative to make a team and start the project.