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:
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:
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.
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.