Payback Period

Payback Period or Payback Method

The Payback Method is used to calculate the number of periods that must pass before the net after–tax cash inflows from an investment will equal, or “pay back,” the initial investment cost. A company using the payback method will choose its desired payback period. Projects with payback periods of less than the chosen amount of time are candidates for further consideration, while projects with payback periods in excess of the chosen amount of time are rejected.

If the expected cash inflows are constant over the life of the project, the payback period can be calculated as follows:

If the expected cash inflows are not constant over the life of the project, the payback period is calculated by determining the cumulative net cash flow (inflows and outflows) at the end of each year of the project’s life (including Year 0) to find in which period the inflows will equal the outflows.

Benefits of the Payback Method of Capital Budgeting

1. • It is simple and easy to understand.
2. When a company has several proposals to consider, the payback method can be useful for preliminary screening by showing which ones will recoup the company’s investment quickly.
3. It can be useful when expected cash flows in later years of the project are uncertain. Cash flow predictions for periods far in the future are less certain than predictions for three to five years ahead.
4. It is helpful for evaluating an investment when the company desires to recoup its initial investment quickly.
5.  Since the Payback Method favors projects with short time horizons, it can be used to concentrate on more liquid projects and thus avoid tying up capital for long periods of time.
6. The Payback Method can help a company manage risk when evaluating the feasibility of a project in an unstable environment, where quick profit-making is preferable.

Limitations of the Payback Method of Capital Budgeting

1. It ignores all cash flows beyond the payback period and does not consider total project profitability. Therefore, a project that has large expected cash flows in the latter years of its life could be rejected in favor of a less profitable project that has a larger portion of its cash flows in its early years.
2. The Payback Method does not incorporate the time value of money. Therefore, interest lost while the company waits to receive money from the project is not considered.
3. It does not consider a project’s return on investment.
4. It does not consider a project’s profitability or the amount of risk.
5. It ignores the cost of capital, so the company could accept a project for which it will pay more for its capital than the project can return.