The payback period is the time required for the amount invested in an asset to be repaid by the net cash flow generated by the asset. It is a simple way to evaluate the risk associated with a proposed project. An investment with a shorter payback period is considered to be better, since the investor's initial outlay is at risk for a shorter period of time. The calculation used to derive the payback period is called the payback method. The payback period is expressed in years and fractions of years. For example, if a company invests $300,000 in a new production line, and the production line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback).
The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash inflow generated by the project per year (which is assumed to be the same in every year).
Payback Period Example
Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0 years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. The payback period for this capital investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using the payback method as the basis for its investment decision, it would buy the conveyor system, since it has a shorter payback period.
Payback Method Advantages and Disadvantages
The payback period is useful from a risk analysis perspective, since it gives a quick picture of the amount of time that the initial investment will be at risk. If you were to analyze a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods and reject those having longer ones. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial investment is therefore a serious concern. Though the payback method is widely used due to its simplicity, it suffers from the following problems:
- Asset life span. If an asset’s useful life expires immediately after it pays back the initial investment, then there is no opportunity to generate additional cash flows. The payback method does not incorporate any assumption regarding asset life span.
- Additional cash flows. The concept does not consider the presence of any additional cash flows that may arise from an investment in the periods after full payback has been achieved.
- Cash flow complexity. The formula is too simplistic to account for the multitude of cash flows that actually arise with a capital investment. For example, cash investments may be required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows may change significantly over time, varying with customer demand and the amount of competition.
- Profitability. The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all. Thus, the method may indicate that a project having a short payback but with no overall profitability is a better investment than a project requiring a long-term payback but having substantial long-term profitability.
- Time value of money. The method does not take into account the time value of money, where cash generated in later periods is worth less than cash earned in the current period. A variation on the payback period formula, known as the discounted payback formula, eliminates this concern by incorporating the time value of money into the calculation. Other capital budgeting analysis methods that include the time value of money are the net present value method and the internal rate of return.
- Individual asset orientation. Many fixed asset purchases are designed to improve the efficiency of a single operation, which is completely useless if there is a process bottleneck located downstream from that operation that restricts the ability of the business to generate more output. The payback period formula does not account for the output of the entire system, only a specific operation. Thus, its use is more at the tactical level than at the strategic level.
- Incorrect averaging. The denominator of the calculation is based on the average cash flows from the project over several years - but if the forecasted cash flows are mostly in the part of the forecast furthest in the future, the calculation will incorrectly yield a payback period that is too soon. The following example illustrates the problem.
Payback Method Example #2
ABC International has received a proposal from a manager, asking to spend $1,500,000 on equipment that will result in cash inflows in accordance with the following table:
The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct.
Instead, the company's financial analyst runs the calculation year by year, deducting the cash flows in each successive year from the remaining investment. The results of this calculation are:
|Year||Cash Flow||Net Invested Cash|
The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years.
The payback method should not be used as the sole criterion for approval of a capital investment. Instead, consider using the net present value or internal rate of return methods to incorporate the time value of money and more complex cash flows, and use throughput analysis to see if the investment will actually boost overall corporate profitability. There are also other considerations in a capital investment decision, such as whether the same asset model should be purchased in volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would make more sense than an expensive "monument" asset.
The payback period formula is also known as the payback method.