The Payback Method

The payback period in capital budgeting refers to the period required for the return on an investment to "repay" the sum of the original investment.

Payback period, as a tool of analysis, is often used because it is easy to apply and understand for most individuals, regardless of academic training or field of endeavor. When used carefully or when comparing similar investments, it can be quite useful. All else being equal, shorter payback periods are preferable to longer payback periods. As a stand-alone tool to compare an investment to "doing nothing," the payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return on the investment consists of reduced operating costs.

However, primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as an energy payback period (the period over which the energy savings of a project equal the amount of energy expended since project inception). These other terms may not be standardized or widely used.

The payback period is an effective measure of investment risk. A project with the shortest payback period has less risk than a project with a longer payback period. The payback period is often used when liquidity is an important criterion when choosing a project.

Monthly liquidity of an organic vegetable business Cash demand is high from April to August. The business will likely choose a project based on a payback period.

The payback period method is suitable for small investment projects. It is not worth spending much time and effort on sophisticated economic analysis in such projects.

Capital Investment in Plant and Property The payback method is a simple way to evaluate the number of years or months it takes to return the initial investment.