Defining the Payback Method


In capital budgeting, the payback period refers to the period of time required for the return on an investment to "repay" the sum of the original investment.

The payback method is often used as a tool of analysis because it is easy to apply and understand for most individuals, regardless of academic training or field of endeavor. When used carefully to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment, the payback method has no explicit criteria for decision-making except, perhaps, that the payback period should be less than infinity.

The payback method is considered a method of analysis with serious limitations and qualifications for its use because it does not account for the time value of money, risk, financing, or other important considerations, such as opportunity cost. While the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.

Economists prefer alternative measures of "return," such as net present value and internal rate of return. The payback method implicitly assumes that returns to the investment continue after the payback period. The method does not specify any required comparison to other investments or even to not making an investment.


Inside a factory, large machines with yellow, rounded exteriors sit on a red floor. Overhead lights and large windows.

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.


The payback period is usually expressed in years. Start by calculating net cash flow for each year: net cash flow year one = cash inflow year one - cash outflow year one. Then cumulative cash flow = (net cash flow year one + net cash flow year two + net cash flow year three). Accumulate by year until cumulative cash flow is a positive number, which will be the payback year.

Key Points

  • The payback period is the number of months or years it takes to return the initial investment.

  • To calculate a more exact payback period: payback period = amount to be invested / estimated annual net cash flow.

  • The payback method also ignores the cash flows beyond the payback period; thus, it ignores the long-term profitability of a project.

Terms

  • Opportunity Cost – the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

  • Cost of Capital – the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

  • Time Value of Money – the value of money, figuring in a given amount of interest, earned over a given amount of time.

Example

  • A $1,000 investment, which returned $500 per year, would have a two-year payback period.

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