What is a payback period?

Payback period analysis is a method used to determine the relative time value of a project. It measures the time that a project will take to return its initial investment. The total time taken by the project to return the initial investment made for the project is called the payback period.

If the payback period is short, the project will start receiving profits earlier, which will attract more investment in the project. Furthermore, payback period analysis helps in calculating and managing the risk. Hence, it is an essential factor for decision-making.

How to measure the payback period?

The payback period formula is also known as the payback method. The payback period for any project can be calculated using the following formula:

$Payback period = \frac{Initial investment - Opening cash flow}{Clo\sin g cash flow - Opening cash flow}$ 

OR

$Payback period = \frac{Initial investment}{Annual net cash flow}$

Here, 

• The initial investment will be the total amount used to purchase the asset, product, or fund.
• The opening cash flow is the cash flow available at the start of the year.
• The closing cash flow is the cash flow obtained at the end of the year.
• Annual net cash flow is calculated by subtracting the opening cash flow from the closing cash flow.

An example of payback period

Consider an organization that wants to expand its production line for bags by investing $150,000. The organization receives a profit of $40 for every bag. The expansion will increase their production by 1,250 bags per annum. The sales manager has guaranteed the company investors that their bags are in high demand, and the company will manage to sell the increased production.

The expansion in the production will raise the annual cash flow by $50,000 per year (1,250 x 40/ bag). At this rate, the organization will get a total of $150,000 cash flow for the initial three years after the expansion.

So, what will be the payback period?

Answer: According to the question,

Initial investment = $150,000

Net annual cash flow = $50,000 per year

Therefore, the payback period = $\$150,000 / \$50,000$

Payback period = 3 years

Advantages of calculating payback period

There are several benefits of calculating the payback period which include:

• If the payback period is longer, the investor or organization can be aware of the capital being tied up.
• The investment risk can be measured using the payback method.
• The short-term profits can be analyzed.
• Calculation of the payback period is a simple process.
• No technical knowledge is needed to calculate the payback period.
• The concept of the payback method is easy to understand. 

Drawbacks of calculating payback period

Payback period analysis does have several drawbacks, including:

• If the value of the product or asset expires after paying back the initial investment, the chances of obtaining profit from the investment will end. Payback period analysis does not determine this factor.
• The payback method does not consider any extra investment added to the initial investment.
• The payback method does not calculate the multitude of cash flows that come with capital investment.
• This analysis method only focuses on calculating the time needed to pay back the initial investment. It does not measure the project profitability at all.
• The payback method does not consider the time value of money, where the profit obtained in the later period is lesser than that obtained in the current period.
• For a single operation to be successful, multiple assets would be needed to be purchased. However, in such cases, the payback period does not calculate the output for the entire system. It only calculates the results for a single operation.

When to use the payback method

Considering the advantages and disadvantages of payback period analysis, the technique is only applicable to some cases which are listed below:

• Payback period analysis is used by companies that do not have lots of cash in hand.
• The method works best for dynamic markets that have an uncertain investment.
• In businesses where investors are looking to invest in ventures having a shorter payback period.
• Companies that are facing a liquidity crisis and want their investment back in less time.

Discounted payback period

The discounted payback period is a variation of the payback period. One of the disadvantages of the payback period is that it does not consider the time value for money. However, in the discounted payback period, this disadvantage is resolved.

The discounted payback period is the time (in years) that the initial project investment takes to get equal to the discounted value of the expected cash flows. In other words, it is the time taken to break even from the initial investment.

The discounted payback period is computed using the following formula:

$\frac{(Year before the discounted payback period occurs + cumulative discounted cash flow in a year before recovery)}{ (Discounted cash flow in a year after recovery)}$

Context and Applications

The payback period analysis is an important topic taught in the system analysis and design subject. The concept is covered in the following courses:

• Bachelors in Computer Science or Information Technology
• Masters in Computer Science or Information Technology

Practice Problems

Q1. Which of these methods does not consider the project's entire life to calculate capital budgeting?

1. Payback period
2. Internal rate return
3. Profitability index
4. None of the above

Answer: Option a

Explanation: The payback period does not take into account the entire life of the project while calculating the return. Therefore, if the project fails after paying back the initial investment, the payback period fails to determine that during the analysis.

Q2. Which of these methods calculates the time to recover the initial investment done in a project?

1. Single cash flow method
2. Payback method
3. Profitability index
4. All of the above

Answer: Option b

Explanation: The payback method, also known as payback period analysis, determines the time an asset/ project will take to pay back the initial investment done for the asset/ project.

Q3. If the initial investment is $6850000 and the annual cash flow is $2050000, what will be the payback period?

1. 4.18 years
2. 5.24 years
3. 3.34 years
4. 4.51 years

Answer: Option c

Explanation: The payback period is calculated as initial investment/ annual cash flow. Therefore, the payback period will be

$\$6850000/ \$2050000 = 3.34 years.$

Q4. If the initial investment is $765000 and the payback period is 4.5 years, what will be the annual cash flow?

1. $170000
2. $4232560
3. $346098
4. $659800

Answer: Option a

Explanation: The payback period is calculated as

$$\begin{gathered} Payback period = \frac{Initial investment}{Annual cash flow} \\ 4.5 years =\frac{\$765,000}{Annual cash flow} \\ Annual cash flow = \frac{\$765,000}{4.5}=\$170,000 \end{gathered}$$

Q5. Which of the following is a drawback of the payback method?

1. It determines the return period of the initial investment.
2. It does not consider the time value of money.
3. It is used for companies facing a liquidity crisis.
4. None of these

Answer: Option b

Explanation: The major drawback of the payback method is that it does not take into account the time value of money while calculating the payback period.

Common Mistakes

Students often ignore the difference between discounted payback period and the payback period. They consider both the terms as the same. However, there is only a minor difference between these terms. In payback period analysis, the time value of money is not considered, whereas it is considered in the discounted payback period.

Related Concepts

• Capital budgeting
• Investment
• Internal rate of return
• Financial analysis