2 Excluding cash flows after payback

Another limitation of payback period is that it excludes the cash flows that occur after the payback period is reached. This means that it does not capture the full profitability and risk of the project, especially if the project has a long life span and significant cash flows in the later years. For example, a project that pays back in two years with low cash flows afterwards may seem more attractive than a project that pays back in three years with high cash flows afterwards, even though the latter may have a higher NPV and IRR.

To avoid this pitfall, you should complement the payback period with other decision criteria, such as NPV and IRR, that consider the entire stream of cash flows over the project's life span. This way, you can balance the trade-off between liquidity and profitability and account for the risk and uncertainty of the future cash flows.

3 Using arbitrary cutoffs

A third problem with payback period is that it requires an arbitrary cutoff point to accept or reject a project. This cutoff point, also known as the payback criterion, is usually based on the management's preferences, expectations, or industry standards, but it may not reflect the true opportunity cost of capital or the optimal investment strategy. For example, a project that pays back in four years may be rejected if the payback criterion is three years, even though it may have a positive NPV and IRR and offer a higher return than the alternative use of funds.

To avoid this pitfall, you should use a payback criterion that is consistent with your cost of capital, your risk appetite, and your strategic goals. You should also compare the payback period with the project's life span and the break-even point to assess its viability and sustainability.

4 Overlooking non-financial factors

A fourth issue with payback period is that it focuses only on the financial aspects of the project and overlooks the non-financial factors that may also influence the decision. These factors may include the environmental, social, ethical, legal, or strategic implications of the project, such as its impact on the stakeholders, the reputation, the market share, or the competitive advantage of the firm. For example, a project that pays back in five years may be accepted if it aligns with the firm's mission, vision, and values, even though it may have a low NPV and IRR and entail significant risks and costs.

To avoid this pitfall, you should consider the non-financial factors along with the financial factors when evaluating a project. You should also use a multi-criteria approach that weights and ranks the different factors according to their importance and relevance to the decision.

Payback period is a useful tool to measure the liquidity and simplicity of an investment project, but it also has some limitations and drawbacks that can affect your decision making. By being aware of these pitfalls and mistakes and applying some corrective measures, you can improve your cash flow analysis and make more informed and rational investment decisions.