The payback period (PBP) is the number of years it takes to recover the initial cost of an investment. Because the payback period is a measure of liquidity, for a firm with liquidity concerns, the shorter a project’s payback period, the better. However, project decisions should not be made on the basis of their payback periods because of the method’s drawbacks.
The main drawbacks of the payback period are that it does not take into account either the time value of money or cash flows beyond the payback period, which means terminal or salvage value wouldn’t be considered. These drawbacks mean that the payback period is useless as a measure of profitability.
The main benefit of the payback period is that it is a good measure of project liquidity. Firms with limited access to additional liquidity often impose a maximum payback period and then use a measure of profitability, such as NPV or IRR, to evaluate projects that satisfy this maximum payback period constraint.