Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected
to be recovered from the cash inflows generated by the investment or 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 one of the simplest investment appraisal
techniques. 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.

Formula

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:
Initial Investment
Payback Period =
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for
each period and then use the following formula for payback period:

Disadvantages

Ignores the time value of money: The most serious disadvantage of the payback
method is that it does not consider the time value of money. Cash flows received during
the early years of a project get a higher weight than cash flows received in later years.

Neglects cash flows received after payback period: For some projects, the largest
cash flows may not occur until after the payback period has ended. These projects
could have higher returns on investment and may be preferable to projects that have
shorter payback times.

Ignores a project's profitability: Just because a project has a short payback period
does not mean that it is profitable. If the cash flows end at the payback period or are
drastically reduced, a project might never return a profit and therefore, it would be an
unwise investment.

Does not consider a project's return on investment: Some companies require

capital investments to exceed a certain hurdle of rate of return; otherwise the project is
declined. The payback method does not consider a project's rate of return.
Advantages:

1. An investment project with a short payback period promises the quick inflow of
cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which liquidity
is very important.
3. An investment with short payback period makes the funds available soon to
invest in another project.
4. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.
5. Payback period is very easy to compute.