BUS202: Principles of Finance

Payback period as a tool of analysis is easy to apply and easy to understand, yet effective in measuring investment risk.

TERMS

• 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

• 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.

Payback period in capital budgeting refers to the period of time required for the returnon 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 easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare 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," 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 to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time 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. The project with a shortest payback period has less risk than with the project with longer payback period. The payback period is often used when liquidity is an important criteria to choose a project .

Payback period method is suitable for projects of small investments. It not worth spending much time and effort on sophisticated economic analysis in such projects.