Question
What is the Payback Period method? Explain its acceptance criteria and discuss its
limitations as a capital budgeting technique.
Answer :
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The Payback Period method is one of the simplest and most widely used traditional techniques of capital budgeting. It refers to the length of time required for a project to recover its initial investment from the cash inflows generated by that project. In other words, it measures the period within which the original investment is recovered. It is generally expressed in years and is particularly useful for assessing the liquidity and risk associated with an investment proposal. When annual cash inflows are equal, the Payback Period can be calculated using the following formula: Payback Period = Initial Investment / Annual Cash Inflow For example, if a project requires an initial investment of ₹5,00,000 and generates annual cash inflows of ₹1,00,000, its payback period will be 5 years. When cash inflows are unequal, the cumulative cash inflows are calculated year by year until the initial investment is fully recovered. If the investment is recovered during a particular year, the fraction of the year required can also be calculated. The acceptance criteria under the Payback Period method depend upon the predetermined maximum acceptable payback period of the firm. If the actual payback period of
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