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Why it is still considered an effective tool for evaluation of investment projects ?
The payback period is useful from a risk analysis perspective, since it gives a quick picture of the amount of time that the initial investment will be at risk. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial investment is therefore a serious concern.
However it is not considered appropriate due to following issues:
1) Asset life span is ignored.
2) Additional cash flows are ignored.
3) Cash flow complexity is not accounted for properly
4) The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all.
5) Time value of money is ignored however a variation on the payback period formula, known as the discounted payback formula, eliminates this concern by incorporating the time value of money into the calculation.
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