The Payback Period is the amount of time it takes to pay back the original investment amount of a project with cash inflows. It is the amount of time it takes for a project to reach break even point. The shorter a payback period, the more attractive the investment is, as this means it takes less time to recover the initial investment. It is a very useful metric for investors and managers when making capital budgeting and investment decisions.
The Payback Period is a relatively simple calculation with only 2 variables required to return a value for the payback period. It is one of the common analytical tools used by managers and investors, along with the Net Present Value, Accounting Rate of Return, and the Internal Rate of Return.
The initial investment value is the initial cash outflow required to start a project. In the Payback Period calculation, this value is divided by the sum of all cash inflows over the life of the project to deliver a year value for the payback period.
The average periodic cashflow payment is the average expected or predicted cash inflow value of a project for all periods for the duration of the project’s life. They are the expected profit for a period minus expenses required to maintain the project for all periods, divided by the total number of periods.
The Payback Period value is the number of periods, generally measured in years, that it will take to payback the initial investment of a project. This value is often rounded up to the higher year value as inflows are paid at the end of a period. For example, a project that calculated a payback period value of 3.1 years would be rounded up to 4 years as the 0.1 would not be paid until the end of the fourth period.
The Payback Period is used to determine the break-even point of a project or investment. The break-even point is where the amount spent on initialising a project or investment is recovered through cash inflows, all inflows thereafter being considered profit of the project.
To demonstrate the application of the Payback Period, we will follow the following example. Assume a manager is wanting to know the break-even point of a potential project and needs to calculate the payback period. The project has an initial investment value of $10,000 and has a life of 5 years. The project is expected to make cash inflows of $5,000, $5,500, $4,000, $6,000 and $5,750 over the 5 periods, respectively. The manager calculates the payback period as follows.
PP = C0 / (Σ Cn) / n
PP = 10,000 / ((5,000 + 5,500 + 4,000 + 6,000 + 5,750) /5)
PP = 1.9 years = 2 years
The Payback Period for this project would be 1.9 years, or 2 years rounded up. The depending on other projects being evaluated and their payback period result, the manager would consider this project over other projects so long as the payback period were shorter.
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. If you were to analyse a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods and reject those having longer ones. 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.
Though the Payback Period is widely used, it does suffer from some disadvantages such as a disregard for asset lifespan, disregarding cashflows after the payback period has lapsed, and disregarding the profitability of a project as it only accounts for the break-even point.
Other issues with the payback period method are time-value of money and accounting for cash inflows that are not equal for the duration of the project’s life. However, the On Equation Finance Formula Calculator adjusts the cash inflows of the payback period to adjust for the time value of money, as well as calculates the Payback Period in a super fancy computer way that gets around the problem of uneven periodic cashflow payments.
The Payback Period is the amount of time it takes to pay back the original investment amount of a project with cash inflows. The Payback Period should not be used as the sole criterion for approval of a capital investment. Instead, consider using the Net Present Value (NPV), Accounting Rate of Return (ARR), or Internal Rate of Return (IRR) methods to incorporate the time value of money and more complex cash flows, and use throughput analysis to see if the investment will actually boost overall corporate profitability. There are also other considerations in a capital investment decision, such as whether the same asset model should be purchased in volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would make more sense than an expensive "monument" asset.
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