This method is very popular as it helps in evaluating the profitability of any investment proposal.
The method helps in estimating the time period in which the invested cash will come back to the business from any investment. It is really useful in making investment-related decisions.
The cash payback method can also be used to compare two different investment proposals.
It is also very important for financial institutions and creditors who rely on the cash flow for paying back of debts, which are associated with the investment of capital.
Limitations of Cash Payback Method
It fails to consider the time value of money.
It does not take into consideration the annual cash flows after the payback period.
The cash payback period refers to the expected period of time required to fully recover the cash or the amount invested in some other forms. Unlike the average rate of return method, analysts focus on cash flows and not accounting income. The difference between accounting income and cash flow is that the former includes deferrals and accruals. Analysts believe that using cash flows in order to assess any investment proposal makes more sense because the overall benefits and losses of any form of capital investment are best indicated through cash flows. Simply put, the business has invested its cash and would, therefore, want cash in return. The calculation under the payback method depends on the timing as well as the amount of the cash flows. Cash flow consists of cash inflows and cash outflows. The difference between cash inflow and cash outflow results in the net cash flow.
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