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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.
The payback period is often determined using a tool of analysis called the payback method, because it is easily applicable and understandable for most people, regardless of their level of academic training or particular field of endeavor. The payback method can be beneficial to compare similar investments, when applied carefully. The only explicit criteria required when utilizing the payback method as a self-contained tool to compare an investment is that the payback period should be less than infinity; other than this qualifier, the payback method has no specific criteria for decision-making.
As a method of analysis, there are, however, some significant limitations and qualifications attached to using the payback method; namely, it fails to account for considerations such as the time value of money, risk, financing, and opportunity cost. Now, the issue with the time value of money can be remedied by applying a weighted average cost of capital discount. Prevailing opinion dictates that this particular tool for investment decisions should not be used in a vacuum or isolation. Alternatively, economists prefer measures of return like net present value and internal rate of return.
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:
Accumulate by year until the cumulative cash flow is a positive number; this year will be the payback year.
IN CONTEXT
Suppose a business is considering investing $150,000 in a project with the anticipated net cash flows:The business will experience the payback period during Year 4 since the investment is recovered during this period.
- Year 1: $60,000
- Year 2: $30,000
- Year 3: $45,000
- Year 4: $35,000
- Year 5: $50,000
Year Investment Cashflow Cumulative Cash Flow Year 0 -$150,000 0 -$150,000 Year 1 0 $60,000 -$90,000 Year 2 0 $30,000 -$60,000 Year 3 0 $45,000 -$15,000 Year 4 0 $35,000 $20,000 Year 5 0 $50,000 $70,000
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:
IN CONTEXT
Suppose a business has the following net cash flows:
- 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 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.
EXAMPLE
A 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:
IN CONTEXT
Suppose a project costs $10,000. If it will return $2,000 each year in profit (after all expenses and taxes), then this means that it will take a total of 5 years without a time value of money discount being applied. However, applying time value of money is a fairly simple process, and can be accomplished utilizing the discounted cash flow analysis equation.
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.
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