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.
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. 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 payback period 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 the opportunity cost. Whilst 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. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.
Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.
Definition of 'Payback Period'
The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.
Calculated as:
Payback Period = Cost of Project / Annual Cash Inflows
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:
Payback Period = A +
B
C
In the above formula,
A = Last period with a negative cumulative cash flow,
B = Absolute value of cumulative cash flow at the end of the period A,
C = Actual cash flow during the period after A.
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below.
Decision Rule
Accept the project if it's payback period is less than the target payback period. Do not accept otherwise.
EXAMPLES
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $100 million. The project is expected to generate $25 million per year for 10 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment / Annual Cash Flow = $100M / $25M = 4 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in millions)
Cumulative
Cash Flow
Year
Cash Flow
0
(50)
(50)
1
10
(40)
2
13
(27)
3
16
(11)
4
19
8
5
22
30
Payback Period = 3 + ( |-$11M| / $19M )
Payback Period = 3 + ( $11M / $19M )
Payback Period = 3 + 0.58
Payback Period = 3.58 years
Considerations for using payback period
Payback period is an appealing metric because it has an easily understood meaning. Nevertheless, here are some points to keep in mind when using payback period:
Payback cannot be calculated if the positive cash inflows do not eventually outweigh the cash outflows. That is why payback (like IRR) is of little use when used with a pure "costs only" business case or cost of ownership analysis.
There can be more than one payback period for a given cash flow stream. Payback period examples such as the one above typically show cumulative cash flow increasing continuously. In real world cash flow results, however, cumulative cash flow can decrease as well as increase from period to period. When cumulative cash flow is positive in one period, but negative again in the next, there is more than one Payback Period point.
Payback period by itself says nothing about cash flows coming after the payback time. One investment may have a shorter payback period than another, but the latter may go on to greater cumulative cash flow over time.
Payback calculation ordinarily does not recognize the time value of money (in discounting sense) nor does it reflect money coming in after payback (contrast with discounted and internal rate of return, above).
Advantages and Disadvantages
Advantages of payback period are:
Payback period is quite simple to calculate.
It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are.
For companies facing liquidity problems, it provides a good ranking of projects that would return money early.
Disadvantages of payback period are:
Payback period does not take into account the time value of money which is a serious drawback since it could lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method.
It does not take into account, the cash flows that occur after the payback period is reached.
The payback period also ignores the salvage value and the total economic life of the project.
The payback period is more a method of capital recovery rather than a measure of profitability of a project.
The payback period is designed to cover the conventional projects that involve large up-front investment followed by positive operating cash inflows. It breaks down, however, when the investment is spread over time or where there is no initial investment.
Calculation of payback period of machines
Machine1
Machine2
Machine3
Initial investment(a)
Rs.3,00,000
Rs.3,00,000
Rs.3,00,000
Sales(b)
5,00,000
4,00,000
4,50,000
Costs:
Direct material
40,000
50,000
48,000
Direct labour
50,000
30,000
36,000
Factory overhead
60,000
50,000
58,000
Depreciation
1,30,000
91,667
90,000
Administration cost
20,000
10,000
15,000
Selling and Distribution costs
10,000
10,000
10,000
Total cost ©
3,10,000
2,41,667
2,57,000
Profit before tax (b-c)
1,90,000
1,58,333
1,93,000
Less: tax @ 40%
76,000
63,333
77,200
Profit after tax
1,14,000
95,000
1,15,800
Add: depreciation
1,30,000
91,667
90,000
Net cash flow(d)
2,44,000
1,86,667
2,05,800
Payback period (years) (a/d)
1.23
1.61
1.46
Machine 1 has lowest payback period, so it may be preferred over the other two machines.
