The payback period refers to the time when an investor earns back their initial investment. It’s the point at which an asset begins to generate a profit. A capital investment’s payback period is the amount of time it takes for the project’s cash inflows to equal the cash outflows.
For example, the payback period for a two-year investment would be two years if the initial investment of $2,000 yielded $1,000 at the end of the first and second years each. Payback or recoupment times are typically given in years.
Ideally, payback periods should be brief. Recouping the initial cost of a project or investment must be fast. However, not all projects and investments have the same time horizon, so the shortest payback period must fall within that range. The payback period on a home repair project may be decades, but a construction project may be five years or less.
Why Take Payback Time into Account?
As mentioned earlier, the payback period is the amount of time in years needed to retrieve one’s initial monetary investment.
Due to its easy application to almost any situation and understood by people of varying education and experience, the payback period is frequently used as an analytical tool in the financial sector. It’s an excellent tool for comparing investments of a similar type.
A payback period is a comparative tool between investment and doing nothing. Still, it does not provide any other criteria for making a choice (except, perhaps, that the payback period should be less than infinity).
If anyone wants to evaluate risks quickly but in years rather than dollars, try using the payback period instead of a break-even analysis. Payback periods indicate how long it will take for an investor to recoup their initial investment.
Companies use the payback period to determine the rate of return on any investment, whether it be a new piece of equipment or an upgrade to an existing piece of software, just as the financial sector does.
Influential Factors on the Payback Time
The payback period will change depending on how much money someone has put into the project. The longer it takes for a project to earn back its initial investment, the higher the investment cost.
- To calculate the payback period, one has to consider the timing and size of the cash inflows and outflows related to the project. When cash flow increases, payback time decreases, and vice versa.
- The interest rate on the initial investment influences the payback period. Higher interest rates result in a shorter time needed to repay the loan.
- Tax rates determine how quickly a project retrieves the investment costs if it produces taxable income. The time it takes to recoup initial investment increases as the tax rate does.
- Due to the discounting of cash flows, inflation affects the payback period. The payoff period will be longer if inflation is high.
Payback Period Calculation
To know the time it will take for a project to pay for itself, you must divide its initial cash outlay by its annual net cash inflow. You can assume that the annual net cash inflow is constant for the payback period formula.
Years or fractions of years are used for the final figure. Anyone can calculate the payback period using the formula:
Payback Period = Initial Investment (I) / Annual Return
If a company spends $100,000 on new manufacturing equipment and sees a $20,000 annual return on its investment, it would have a positive cash flow.
Time to Break Even = $100,000 / $20,000
If we divide $1,000,000 by $20,000, we get a payback time of 5 years.
Disadvantages of the Payback Period
Since the payback period only considers cash inflows and outflows until the initial investment has been recovered, it is often criticized for being insufficient. It ignores the cash flow forecast horizon. One must know some disadvantages of the payback period in general or for a project before considering it.
The usefulness of a resource or its lifespan: When an asset pays back its initial investment, it can no longer generate cash flows. The payback approach makes no assumptions about the useful life of assets.
Time Value of Money: Today’s money is worth more than tomorrow’s because of interest, a factor that people often do not consider.
Averaging Error: The calculation’s denominator relies on the project’s average cash flows over several years. Still, if most of the expected cash flows are in the part of the forecast that is farthest away, the calculation will give a payback period too short.
Profitability: It does not consider profitability. If you only look at the payback time, you might miss investments with a higher return.
The Infusion of New Funds: The idea disregards the possibility of future cash flows from an investment that may occur in periods beyond the point of total payback.
Not Suitable for Long Projects: The payback period is more appropriate for smaller projects because it can take a long time for larger projects to recoup their initial investment. The payback period calculation may be off for these projects.
Asset-focused: Many fixed asset purchases aim to improve the efficiency of a single operation, which is useless if a bottleneck downstream limits the business’s output. The payback period formula only considers a specific system operation. It’s more tactical than strategic.
The Bottom Line
Even though the payback period in a project has many benefits, still, the payback method alone is insufficient justification for an item of capital expenditure. Consider throughput analysis and other ways that consider the time value of money and more complex cash flows to determine whether or not the investment will increase the company’s worth. There are additional factors to think about when deciding on capital investment.
They include analyzing whether or not buying multiples of the same model of an asset would reduce maintenance costs. Or if purchasing multiple cheaper and smaller capacity units would make more sense than buying one enormous, expensive monumental support. Purchasing an investment is a significant financial commitment, and you must discuss the payback period before making a final decision.
Matthew is a Co-Founder at BusinessFinanceArticles.org. Matthew was a floor manager at a local restaurant in Wales. He lost his job after the pandemic and took initiative to make a team and start the project.