The payback period is the time required to earn back the initial amount of an investment. This concept is most commonly used when deciding whether to invest in a fixed asset that generates positive cash flow. While the payback period is not an overly scientific approach to fixed asset analysis, it is still one of the most commonly-used evaluation methods.
Payback Period Calculation Methods
The payback period can be calculated in two ways. The first approach requires a very simple calculation, which is to divide the amount invested by the average annual cash flows expected to be derived from the investment. However, as we will note in the following example, this approach can yield inaccurate results.
Our example is based on the following table, which reveals ongoing increases in the cash flows expected from a proposed investment. The presented cash flows sum to $10,000,000, which is an average of $2,000,000 per year. The initial investment required to generate these returns is $7,500,000. Based on this information, the payback period appears to be 3.75 years, which is the $7,500,000 cost divided by $2,000,000 per year in average cash flows. The trouble is that, if we add up the cash flows year by year, it is readily apparent that the expected cash flows will not reach the $7,500,000 level until after the four-year mark. The reason for the strong disparity is that the cash flows are so heavily deferred until future years that the average annual cash flows figure is skewed. Because of this issue, the first calculation method can only be used when the expected cash flows are relatively consistent from period to period.
A more accurate approach to deriving the payback period is to calculate it manually, aggregating cash flows in successive periods and comparing the result to the initial investment amount.
When we apply this calculation method to the information provided in the last table, the result is somewhat different. The following table adds an additional column that shows the remaining invested balance that has not yet been paid back by annual cash flows in each of the years. Under this approach, a small residual balance carries forward into the fifth year of the analysis, and is paid back early in that year.
|Cash Flow||Net Investment Remaining|
Evaluation of the Payback Period
The payback method completely ignores the time value of money, and so incorporates no discount factor that would otherwise reduce the amount of cash flows in later years (see the discounted payback period for a solution to this issue). Still, it represents a simple calculation method for roughly estimating the amount of time that invested funds will be at risk of not being returned, and so may be of use in industries where existing products and processes may become obsolete with great rapidity.