Payback reciprocal definition
/What is the Payback Reciprocal?
The payback reciprocal is the payback period for an investment, divided by 1. This reciprocal yields an approximation of the rate of return on an investment, though only when annual cash flows are uniformly even over the lifetime of the investment, and the cash flows from the project will continue forever.
Payback Reciprocal Example
A financial analyst is reviewing a possible investment of $50,000, which will generate positive cash flows of $10,000 per year. The payback period is 5 years, since cash flows of $50,000 will accumulate over the next five years. The payback reciprocal is 1 / 5 years, or 20%. The calculated internal rate of return using this reciprocal is 15% if the assumed cash flow period is 10 years, and reaches 20% only when the assumed cash flows cover a period of 30 years.
When to Use the Payback Reciprocal
It makes sense to use the payback reciprocal when a company needs a quick and simple estimate of an investment’s approximate rate of return, particularly when the cash flows are expected to be uniform over time. This method is especially useful during preliminary project screenings when management needs a fast way to compare multiple investment opportunities. It is most appropriate for low-risk projects where the simplicity of the method outweighs the need for precise accuracy. However, it is less reliable when cash flows are uneven or when long-term profitability is a critical concern.
Disadvantages of the Payback Reciprocal
There are several disadvantages associated with using the payback reciprocal, which are as follows:
Tends to overstate the rate of return. It is quite unlikely that cash flows will continue uninterrupted for a long ways into the future, so the payback reciprocal tends to overstate the actual rate of return of a proposed investment. Instead, it is more realistic to evaluate a project based on the net present value method or the internal rate of return.
Overly simplistic. The reciprocal payback approach provides a rough estimate of the return but does not account for the full complexity of capital investments.
Ignores cash flows beyond the payback period. Since it only focuses on how quickly an investment is recovered, the payback reciprocal does not consider profitability after that point.
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FAQs
How does the payback reciprocal relate to the accounting rate of return?
The payback reciprocal is sometimes used as a rough proxy for the accounting rate of return when project cash inflows are relatively even. Unlike the accounting rate of return, it is based on cash recovery rather than accounting income. Both measures ignore the time value of money and therefore provide only approximate indications of profitability.