In the context of capital budgeting, the payback period refers to the amount of time it takes for an investment, by way of return, to recover the cost of the initial investment.
When utilizing the payback method, it is implicitly assumed that returns to the investment persist after the payback period. Lastly, it should be noted that the payback method does not cite required comparisons, to either other investments or to a scenario of not making an investment at all.
The payback period is usually expressed in years. Start by calculating net cash flow for each year, which is the cash inflow subtracted by the cash outflow for that year. Then calculate the cumulative cash flow:
The payback period method does not take into account the time value of money. Some businesses modified this method by adding the time value of money to get the discounted payback period. They discounted the cash inflows of the project by a chosen discount rate (cost of capital), and then followed the usual steps of calculating the payback period.
The calculation becomes more complex when the cash flow fluctuates between positive and negative values multiple times – that is, it contains outflows in the middle or at the end of the project’s lifetime. In this situation, the modified payback period algorithm can be applied:
- Year 0: -$1,000
- Year 1: $4,000
- Year 2: -$5,000
- Year 3: $6,000
- Year 4: -$6,000
- Year 5: $7,000.
The sum of all cash outflows = $1,000 + $5,000 + $6,000 = $12,000.
The sum of all cash inflows = $4,000 + $6,000 + $7,000 = $17,000.
The modified payback period is in year 5, since the cumulative positive cash flows ($17,000) exceed the total cash outflows ($12,000) in year 5.
The payback method is quite a simple concept. The majority of business projects (or even entire business plans for an organization) will require capital. When investing capital into a project, it will take a certain amount of time before the profits from the endeavor offset the capital requirements. Of course, if the project never makes enough profit to cover the start-up costs, it is not an investment to pursue. In the simplest sense, the project with the shortest payback period is most likely the best of possible investments, or the lowest risk, at any rate.
Time is a commodity with cost from a financial point of view. Having the money sooner means more potential investment and thus less opportunity cost. The shorter time scale project also would appear to have a higher profit rate in this situation, making it better for that reason as well.
EXAMPLEA project that costs $100,000 and pays back within 6 years is not as valuable as a project that costs $100,000 which pays back in 5 years.
If a payback method does not take into account the time value of money, the real net present value (NPV) of a given project is also not being calculated. This is a significant strategic omission, particularly relevant in longer-term initiatives. As a result, all corporate financial assessments should discount payback to weigh in the opportunity costs of capital being locked up in the project.
One way to do this is to find the discounted payback period by discounting projected cash flows into present dollars based upon the cost of capital using the following formula:
For the sake of simplicity, let’s assume the cost of capital is 10%, meaning the investor can turn 10% on this money elsewhere and it is their required rate of return. If this is the case, then we can use the following equation:
At your expected $2,000 each year, it will take over 7 years for full payback.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “The Payback Method” TUTORIAL.