Payback Method
The payback method, also known as the payback period, is a simple investment appraisal technique used by businesses to decide whether to undertake a project or investment. The payback period is the length of time it takes to recover the initial cost of an investment.
The basic formula for the payback method is:
Payback Period = Initial Investment / Annual Cash Inflows
In essence, the payback method measures how long it takes for an investment to “pay back” its initial cost out of the cash receipts that it generates. Businesses often use this method when they want to know how long it will take to recover the money they have invested in a project.
However, the payback method has limitations. It doesn’t take into account the time value of money, risk, financing or opportunity costs. Also, it doesn’t consider any benefits that occur after the payback period, so it doesn’t necessarily measure profitability or the total value of a project.
For these reasons, while the payback period might be useful as a simple way to compare investments, it is often used in conjunction with other investment appraisal methods, such as net present value (NPV) or internal rate of return (IRR), which do take into account the time value of money and the profitability of the project over its entire lifespan.
Example of the Payback Method
Imagine a company is considering a project that requires an initial investment of $100,000. The project is expected to generate $20,000 per year for the next 10 years.
Using the payback method, we calculate the payback period as follows:
Payback Period = Initial Investment / Annual Cash Inflows
Payback Period = $100,000 / $20,000 = 5 years
This means that it will take 5 years for the company to recover the initial investment of $100,000. Any cash inflows beyond this period could be considered profit.
However, as stated earlier, it’s important to remember that the payback method doesn’t account for the time value of money. Cash inflows in the later years are valued the same as cash inflows in the earlier years, which may not accurately reflect their actual value. This is why it’s often advisable to use other investment appraisal methods, such as net present value or internal rate of return, in conjunction with the payback method to make more informed investment decisions.
