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Payback Period

from QFinance: The Ultimate Resource

At first glance, payback is a simple investment appraisal technique, but it can

quickly become complex.

WHAT IT MEASURES

How long it will take to earn back the money invested in a project.

WHY IT IS IMPORTANT

The straight payback period method is the simplest way of determining the

investment potential of a major project. Expressed in time, it tells a

management how many months or years it will take to recover the original

cash cost of the project—always a vital consideration, and especially so for

managements evaluating several projects at once.

This evaluation becomes even more important if it includes an examination

of what the present value of future revenues will be.

HOW IT WORKS IN PRACTICE

The straight payback period formula is:

Payback period = Cost of project/Annual cash revenues

Thus, if a project costs $100,000 and is expected to generate $28,000

annually, the payback period would be:

100,000/28,000 = 3.57 years

If the revenues generated by the project are expected to vary from year to

year, add the revenues expected for each succeeding year until you arrive at

the total cost of the project.

For example, say the revenues expected to be generated by the $100,000

project are:

Year Revenue Total

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1 $19,000 $19,000

2 $25,000 $44,000

3 $30,000 $74,000

4 $30,000 $104,000

5 $30,000 $134,000

Thus, the project would be fully paid for in year 4, since it is in that year that

the total revenue reaches the initial cost of $100,000.

The picture becomes complex when the time value of money principle is

introduced into the calculations. Some experts insist this is essential to

determine the most accurate payback period. Accordingly, present value

tables or computers (now the norm) must be used, and the annual revenues

have to be discounted by the applicable interest rate, 10% in this example.

Doing so produces significantly different results:

Year Revenue Present value Total

1 $19,000 $17,271 $17,271

2 $25,000 $20,650 $37,921

3 $30,000 $22,530 $60,451

4 $30,000 $20,490 $80,941

5 $30,000 $18,630 $99,571

This method shows that payback would not occur even after five years.

TRICKS OF THE TRADE

Clearly, a main defect of the straight payback period method is that it

ignores the time value of money principle, which, in turn, can produce

unrealistic expectations.

$10,000 now, rather than the

same sum in fi

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PAYBACK RECIPROCAL in Barron's Business

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A second drawback is that it ignores any benefits generated after the

payback period, and thus a project that would return $1 million after,

say, six years might be ranked lower than a project with a three-year

payback that returns only $100,000 thereafter.

Another alternative to calculating by payback period is to develop an

internal rate of return.

Under most analyses, projects with shorter payback periods rank

higher than those with longer paybacks, even if the latter promise

higher returns. Longer paybacks can be affected by such factors as

market changes, changes in interest rates, and economic shifts.

Shorter cash paybacks also enable companies to recoup an

investment sooner and put it to work elsewhere.

Generally, a payback period of three years or less is desirable; if a

project’s payback period is less than a year, some contend it should

be judged essential.

MORE INFO

See Also:

Appraising Investment Opportunities

Return on Investment

Copyright © Bloomsbury Information Ltd, 2009, 2011, 2012, 2013, 2014

Chicago Harvard MLA

Payback period. (2014). In Qatar Financial Center, & Qatar Financial Center

(Eds.), QFinance: the ultimate resource (5th ed.). London, UK: A&C Black.

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