Definition – Payback period
Payback is the period required by the project to recover its invested funds back in the form of cash. In other words, it is the period in which the project just breaks even. For example, a business wants to invest in a project that will cost $3,000. The project will yield returns of $1,000 per year. So, the payback period will be 3 years (3,000/1,000).
Why does management use the Payback Period? When a business invests in a project, management wants to measure how quickly it can recover its investment. Let’s suppose, you have money, and you want to invest in a profitable project. The first thing that you will consider is the time it takes to recover your investment. Remember that the longer it takes the project to return the original investment, the greater the risk will be. However, if the project generates the original investment quickly, the risk of loss will be much lower. Thus, management can use the payback period to identify suitable projects which will generate the returns quickly.
Payback Period – Calculation
There are two ways to calculate the payback period of the project depending upon the nature of cash flows from the project. These can either be:
- Payback period – Constant Annual Cashflow
- Payback period – Uneven Annual Cashflows
Payback Period – Constant Annual Cashflow
When the cash flows are constant each year, the payback period is found by dividing the initial investment by the annual cash flow.
Payback period = Initial investment / Annual cashflow
Example
Let us take an example, if we buy a machine for $2,000,000 and rent it out, we get equal annual rent of $400,000. The payback period is calculated as:
Payback period = $2,000,000 / $400,000
Payback period = 5 years
Payback Period – Uneven Annual Cashflow
When the annual cash flows are uneven, the payback period is found by a tabular approach. We need to make a cumulative column and see where the cumulative figure turns from negative into ‘0’. That is the payback period of the project. However, to find where exactly the payback period occurs when payback occurs between two years, we need to divide the cumulative figure that is just before the positive figure by the cash flow after which the cumulative figure becomes positive.
The payback period occurs somewhere between the 4th and 5th year. However, to find where exactly the payback period occurs when payback occurs between two years, we need to divide the cumulative figure that is just before the positive figure (5,000) by the cash flow after which the cumulative figure becomes positive (30,000).
Payback Period = 4 years + (5,000/30,000) years
Payback Period = 4 years + 0.17 years
Payback Period = 4.17 years
OR,
Payback Period = 4 years + 0.17 *12 months
Payback Period = 4 years + (5,000/30,000) years
Payback Period = 4 years & 2 months.
Definition Discounted Payback Period
A more sophisticated approach to payback period calculation is discounted payback period.
Discounted Payback Period is the period required by the project to recover invested funds back in the form of cash after considering the time value of money.
Determination of Discounted Payback Period: There are two steps to determine the payback period using discounted payback period method:
- Convert the future cash flows into present value using an appropriate discount rate.
- Determine the payback period using the tabular approach (same as the simple payback period).
Example – Discounted Payback Period
Let us take an example of a company, Foster Digitals Limited. The management of a company is evaluating a new investment project. The cost of capital has been estimated at a rate of 10%. The life of the project is 4 years at the end of which the project will be sold as scrap for $20,000. The following cash flows are expected to arise in this period (including the residual proceeds from the project).
Thus, the discounted payback period lies somewhere between the 3rd and 4th year.
To find where exactly the payback period exists, we need to divide the cumulative figure that is just before the positive figure (78,285) by the cash flow after which the cumulative figure becomes positive (81,960).
Discounted Payback Period = 3 years + (78,295/81,960) years
Discounted Payback Period = 3 years + 0.955 years
Discounted Payback Period = 3.955 years
Or,
Discounted Payback Period = 3 years + (0.955 years *12) Discounted Payback Period = 3 years and 11 months approximately.
Advantages
- It minimizes the time risk. Only those projects that provide the return quickly are suitable under this method. Cash received earlier is less risky than that received later.
- It is suitable for projects involving a computer and IT equipment because technology becomes obsolete soon due to updated versions being available. So, using payback, management tries to recover the investment quickly before an upgrade arrives.
- Management wants to recover invested funds quickly if they foresee good investment opportunities in the future. Payback acts as an initial screening tool and only projects with quick returns are chosen under this model.
Disadvantages
- Complete returns are ignored. Returns only up to payback are considered. For example, there are two investments both of which require $100,000. Investment 1 generates a total return of $110,000 and the payback period occurs in 2 years. On the other hand, Investment 2 generates a total return of $200,000 but payback occurs in 3 years. Under the payback method, Investment 1 would be chosen as it assesses projects with quick returns. However, it is not beneficial for the company in terms of net inflow.
- Time Value of Money (TVM) is ignored in the simple payback method. Cash flows are not adjusted for inflation, and it erodes the project appraisal in real terms.