By James Bell
Payback Period is a “quick and dirty” method of calculating how long it will take to recoup an investment given the assumption or knowledge of future cash in-flows. You essentially have two pieces to this equation, the money you invested and the cash flows that come in each year. If it’s consistent cash flows coming in, you can divide the investment by the annual cash flow to determine how many years it will take for the cash flows to “pay back” the investment. For example, 100K investment that returns 20K a year in cash flows will take 100/20 = 5 years to pay back.
This seems pretty straight forward, so what’s the problem with it? Why did I just call this the “quick and dirty” method?
We are assuming that the cash flows will come in consistently and as forecasted. That we will not need additional investment. We assume that the time value of money and risk are not taken into consideration. You can see that their are a lot of details we are leaving out. In general, this formula does give us a quick look when comparing investments about the time frame it’ll take to bring us back to our break-even point after the initial outlay of cash. A shorter period is typically viewed better.
An important aspect of capital budgeting is being able to compare alternatives and value different operational and investment projects. Sometimes need to quickly evaluate and narrow down different alternatives to then run more thorough evaluations on. We can also use this formula to look at potential cost savings of energy efficient technologies. The payback period is a big selling point in residential solar panels for example. Now, let’s look at the formula which is sometimes referred to as the averaging method.
This is the initial investment or outlay of cash. It’s often cash for capital expenditures that will depreciate over time.
This is the expected cash flows that the investment will return per year. When the cash flows are consistent we use the averaging method described above.
Sometimes the cash flows are irregular for investment, return, or both. In this situation you can map out the cash inflows per year and add them up until the inflows match the investment. This total amount of time to get total cash inflows equal to outflows is the payback period. This alternative method is referred to as the subtraction method.
Because we don’t take profitability into account, looking at this metric alongside Internal Rate of Return (IRR) is useful. There are also what I consider “system” or “big picture” aspects to consider. These include the useful life of assets and the value chain that this project or asset is a part of. Increasing efficiency in one area could create bottlenecks in other areas. For instance, if you have a payback period of 2 years on a sales project that doubles sales, but can’t double production, you have a problem and the bottleneck in production may keep you from realizing your payback period or worse.
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