## The Payback Method

Read this section on the Payback Method of investing and review the examples of how this method is used.

### Defining the Payback Method

The payback method is a method of evaluating a project by measuring the time it will take to recover the initial investment.

#### LEARNING OBJECTIVE

• Define the payback method

#### 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.

• time value of money

The value of money, figuring in a given amount of interest, earned over a given amount of time.

• cost of capital

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

#### EXAMPLE

• A $1000 investment which returned$500 per year would have a two year payback period.

#### 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.

As a tool of analysis, the payback method 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 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. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of the payback method is that returns to the investment continue after the payback period. The payback method does not specify any required comparison to other investments or even to not making an investment .

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

To calculate a more exact payback period: Payback Period = Amount to be initially invested / Estimated Annual Net Cash Inflow.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. The 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.

Source: Boundless