Payback period
Payback period is a financial metric used to assess the amount of time it takes to recoup an investment. It measures how long it will take to recover the cost of an investment. To calculate the payback period, you divide the total cost of the investment by the annual cash flows associated with the project. The result is the number of years it will take to pay off the investment.
Payback period can be a useful tool for making decisions about investments, as it provides an easy-to-understand measure of the time it takes to break even on an investment. However, it does not account for the time value of money, so it may not be the best measure of an investment’s long-term profitability.
Example of Payback period
For example, if an investment costs $10,000 and the annual cash flows associated with the investment are $2,500, the payback period is 4 years. This means it will take 4 years to recover the initial $10,000 investment.
Let’s look at an example of calculating the payback period. Suppose that you are considering an investment with the following cost and cash flows:
- Total cost of investment: $5,000
- Annual cash flows: $1,000
The payback period for this investment is calculated by dividing the total cost of the investment by the annual cash flows associated with the investment:
In this example, it will take five years to recover the initial $5,000 investment.
Formula of Payback period
The formula to calculate the payback period is as follows:
When to use Payback period
- Payback period is most useful for investments with a short lifespan, such as a one-time purchase or short-term project.
- It is also useful for comparing investments with similar lifespans, as it allows for easy comparison of the time it takes to recover the costs of each investment.
- Payback period is also useful for decisions with a low risk, as it does not account for long-term profitability or risk.
When not to use Payback period
- Payback period should not be used for investments with a long lifespan, as it does not account for the time value of money.
- It should also not be used for decisions with a high risk, as it does not account for the potential of future losses or gains.
Types of Payback period
There are several types of payback period that can be used to assess the profitability of investments. These include:
- Simple Payback Period: This is the most basic and straightforward measure of payback period. It simply calculates the time it takes to recover the initial investment.
- Discounted Payback Period: This type of payback period takes into account the time value of money. It discounts the cash flows of the investment over time to account for the fact that money is worth more in the present than in the future.
- Internal Rate of Return (IRR): This is a more complex measure of payback period. It takes into account all of the cash flows associated with an investment, both inflows and outflows, and calculates the rate of return that would make the net present value of the investment equal to zero.
Steps of Payback period
- Step 1: Calculate the total cost of the investment. This is the total amount of money that will be spent on the investment.
- Step 2: Calculate the annual cash flows associated with the investment. This is the total amount of money that will be generated from the investment over the course of one year.
- Step 3: Divide the total cost of the investment by the annual cash flows associated with the investment. This will give you the payback period, which is the number of years it will take to recover the initial investment.
Using the payback period formula, decision makers can quickly assess the amount of time it will take to recoup an investment. However, it is important to note that the payback period does not take into account the time value of money, so it may not be the best measure of an investment’s long-term profitability.
Advantages of Payback period
- Payback period is a simple and intuitive measure of the return of an investment. It is easy to calculate and comprehend, making it an attractive metric for decision makers who need to make quick decisions.
- Payback period is also a useful measure of risk. It provides an indication of how quickly an investment can be recovered in the event that it does not provide the expected return.
Disadvantages of Payback period
- Payback period does not take into account the time value of money, so it may not be the best measure of an investment’s long-term profitability.
- Payback period does not account for cash flows after the payback period has been achieved, so it does not provide a complete picture of an investment’s potential return.
Payback period is a useful metric for decision makers who need to quickly assess the return of an investment. However, it does not take into account the time value of money or cash flows after the payback period has been achieved, so it may not be the best measure of an investment’s long-term profitability.
- Payback period does not take into account the time value of money: It does not consider the fact that a dollar today is worth more than a dollar in the future. This means it does not account for the potential return on the money that is invested.
- Payback period does not account for cash flows after the payback period: After the initial investment has been recovered, any additional cash flows are not taken into account.
- Payback period does not consider risk: It does not account for the potential risk associated with the investment, which could affect the long-term profitability of the investment.
Payback period can be a useful tool for making decisions about investments, but it has several limitations that make it an incomplete measure of a project’s profitability. It does not take into account the time value of money, or the potential for cash flows beyond the payback period, or the risk associated with the investment. As such, it should not be the only factor considered when making investment decisions.
- Net Present Value (NPV): NPV measures the present value of all future cash flows associated with an investment. It takes into account the time value of money, and therefore is a better measure of an investment’s financial returns. The formula for NPV is: \$NPV=\sum_{t=1}^n \frac{CF_t}{(1+r)^t} , where CF is the cash flow associated with the investment at each time period t, and r is the discount rate.
- Internal Rate of Return (IRR): IRR is a measure of the return of an investment over its life span. It is calculated by finding the discount rate that results in a NPV of zero. The formula for IRR is IRR=r, where r is the discount rate.
Payback period is an easy-to-understand measure of the time it takes to break even on an investment. However, it does not account for the time value of money, so it may not be the best measure of an investment's long-term profitability. Net Present Value and Internal Rate of Return are two other approaches that take into account the time value of money and provide a better measure of an investment's financial returns.
Payback period — recommended articles |
Net present value (NPV) — Modified internal rate of return — Profitability index — Accounting rate of return — Return on investment — Net asset value per share — Nominal rate of return — Retention ratio — Annualized rate |
References
- Gorshkov, A. S., Vatin, N. I., Rymkevich, P. P., & Kydrevich, O. O. (2018). Payback period of investments in energy saving. Magazine of Civil Engineering, (2 (78)), 65-75.