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Payback in Project Management

Definition
The payback period can be defined as the length of time that is required for an
investment to have recovered its initial costs of an investment. It can also be defined as
the time period required for the amount invested in an asset to be repaid by the net cash
outflow generated by the asset.
The payback period analysis is one of the simplest methods of a given investment; it can
be expressed in years and fractions of years. Payback period analysis of a project is an
important determinant of whether to undertake the position or project as longer payback
periods are typically not desirable for investment positions. It is uses methods to
compare multiple projects that are vying for company resources
Formula
The calculation used to derive the payback period is called the payback method .
Theand the formula to calculate payback period of a project depends on whether the
cash flow per period from the project is even or uneven. In case they are even the
formula to calculate payback period is!
Payback Period =
Initial Investment/Project
Cash Inflow per Period
"hen cash inflows are uneven there is need to calculate the cumulative net cash flow
for each period and then use the following formula for payback period!
Payback Period = A
!
C
In the above formula
# is the last period with a negative cumulative cash flow;
$ is the absolute value of cumulative cash flow at the end of the period #;
% is the total cash flow during the period after #
Decision "ule
# project is accepted only if its payback period is &'(( than the target payback period.
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. 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 there are problems
associated with the payback period method; highlighted below are some of its
advantages and disadvantages!
Payback #ethod Advanta$es and Disadvanta$es
). Asset life span. If an assets 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. or example, cash
investments may be re!uired 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.
,. "rofitability. The payback method focuses solely upon the time re!uired to pay
back the initial investment# it does not track the ultimate profitability of a pro$ect
at all. Thus, the method may indicate that a pro$ect having a short payback but
with no overall profitability is a better investment than a pro$ect re!uiring a long%
term payback but having substantial long%term profitability.
-. Time value of money. The method does not take into account the time value of
money, where cash generated in later periods is work less than cash earned in
the current period. A variation on the payback period formula, known as the
discounted payback formula, eliminates this concern by incorporating the time
value of money into the calculation.
.. Individual asset orientation. &any fixed asset purchases are designed to improve
the efficiency of a single operation, which is completely useless if there is a
process bottleneck located downstream from that operation that restricts the
ability of the business to generate more output. The payback period formula
does not account for the output of the entire system, only a specific operation.
Thus, its use is more at the tactical level than at the strategic level.
/. Incorrect averaging. The denominator of the calculation is based on the average
cash flows from the pro$ect 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.
%ummary
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 lower0cost and lower0capacity units would make more sense than an
expensive 1monument1 asset.