Payback Period

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Recovering the costs of investments. Explanation of Payback Period.

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What is the Payback Period? Description

The Payback Period is perhaps the simplest method of looking at one or more investment projects or ideas. The Payback Period method focuses on recovering the cost of investments. The Payback Period represents the amount of time that it takes for a capital budgeting project to recover its initial cost.

Calculation of Payback Period. Formula

Payback Period recovering the costs of investments Calculating the Payback Period can be done in the following way:

The Costs of Project / Investment

PP = --------------------------------------------------

Annual Cash Inflows

The Payback Period concept holds that all other things being equal, the better investment is the one with the shorter payback period.

Example of Payback Period calculation

For example, take a project costing a total of $200,000. The expected returns of the project amount to $40,000 annually. The Payback Period would be $200,000 : $40,000 = 5 years.

Benefits of Payback Period

The Payback Period certainly has the virtue of being easy to compute and easy to understand. But that simplicity carries weaknesses with it.

Limitations of the Payback Period

There are at least two major problems associated with the Payback Period model:

1) PP ignores any benefits that occur after the Payback Period. It does not measure total incomes.
2) PP ignores the time value of money.

Because of these two reasons, more professional methods of Capital budgeting are advisable.

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Recent User Comments

    			 
  			   FLORA - Namibia
  	       
  		     Managerial Finance
  	  		 "What if I don't have annual cash flows, should I take the net cash inflows?"
  			   
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  			   Remmy - Australia
  	       
  		     Calculation of Pay back period
  	  		 "How do we calculate payback period when the returns / cashflows are different each year?"
  			   
    	  		 29

    			 
  			   Masego Matseke - South Afric
  	       
  		     Brilliant web resource
  	  		 "I am an Analyst in a South African IT Company, and I am tasked with the financial analysis exercises that requires significant aspects of Capital Budgeting for an internal product developement effort. Being someone who studied finance, but not having practised in the area for about, obviously I'd be rough around the edges on some of techniques. Your website just made it to my number list of web resources that offer descent quality information on literally areas I have practiced in like management consulting"
  			   
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	└► Tichakunda Gumbo (Zimbabwe)	Comment on payback period Tecnique	"Your payback period calculation formular is somehow too generalised in that it assumes that all projects will have equal annual cashflows.What about those with different annual cashflows.?"
	└► Editor (Netherlands)	Payback Period if annual cashflows vary?	"In case the annual cashflows are not the same, the formula is still valid. Suppose the same project is costing $200.000, but now the annual cashflows are: $30.000 (yr 1), $40.000 (yr 2), $50.000 (yr 3), $40.000 (yr 4), $20.000 (yr 5), $20.000 (yr 6), and $50.000 (yr 7). After 6 years the total of all cash inflows equals the costs (investments) in the project. Therefore the Payback Period of our project is 6 years."
	└► Peter Hansen (Neverland)	Good resource	"I found that this was a very useful website with relevant explanations and examples. Keep up the good work!"
	└► Herson Deleon (Philippines)	Calculating payback period	"Yes, it is difficult if the annual income of a certain company is not always constant. Obviously you will use a lot of operation just to get the accurate answer, which is really necessary to business."
	└► Vishwa (India)	Payback period calculation for Uneven cashflow over the years	"Say my initial investment is $15,000 and my subsequent annual cash flows are 1) $11000, 2) $7000 and 3) $4800 Now how do you calculate the cash flow. I am not sure if the cash flows have to be considered with an weighted agerage or should I looke at monthly averages or weekly or daily averages for that year to arrive at a losest figure?"
	└► Ade Osunsanmi (UK)	Pay back Period	"I think the the pay back period is just a cumulative sum of money to PAY BACK the initial investment . If your cash flows in the example you gave are "cash inflows" then the pay back period" occur in the second year since by the end of second year you would have had $18,000 enough to pay $15,000. I hope this helps?"
	└► Gabriel Hogan (Ireland)	Payback period	"Payback period is a great method but if you are considering investments in innovation it has its drawbacks, namely it does not account for the cost (loss of competitive advantage) of doing nothing. See the Innovation Killers article in Harvard Business Review Jan 2008 by Christensen, Kaufman and Shih"
	└► Mukela Namushi Mubano (Zambia)	Payback Period	"I do not think the formula dictates that the cash flows should be the same. Sometimes they may not be. The payback period is the period it takes for one to recoup one's investment. Times are not the same. Sometimes one does well. Sometimes not."