The payback period is an evaluation method used to determine the amount of time required for the cash flows from a project to pay back the initial investment in the project. For example, if a $100,000 investment is needed and there is an expectation of the project generating positive cash flows of $25,000 per year thereafter, the payback period is considered to be four years. The advantages of the payback period are that it is especially useful for a business that tends to make relatively small investments, and so does not need to engage in more complex calculations that take other factors into account, such as discount rates and the impact on throughput.
The calculation of the payback period is:
$100,000 Investment ÷ $25,000 Annual cash flows = 4 Years payback
The usual complaints about the payback period focus on how it ignores subsequent investments and does not account for the time value of money. However, there are advantages to using the payback period, which are as follows:
- Simplicity. The concept is extremely simple to understand and calculate. When engaged in a rough analysis of a proposed project, the payback period can probably be calculated without even using a calculator or electronic spreadsheet.
- Risk focus. The analysis is focused on how quickly money can be returned from an investment, which is essentially a measure of risk. Thus, the payback period can be used to compare the relative risk of projects with varying payback periods.
Consequently, despite its lack of rigorous analysis, there are still situations in which the payback period can be used to evaluate prospective investments. We suggest that it be used in conjunction with other analysis methods to arrive at a more comprehensive picture of the impact of an investment.