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The payback period is the time required to earn back the amount Financial Analysis Value Pack

invested in an asset from its net cash flows. It is a simple way to evaluate
Accounting Bestsellers
the risk associated with a proposed project. An investment with a shorter
Accountants' Guidebook
payback period is considered to be better, since the investor's initial
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outlay is at risk for a shorter period of time. The calculation used to derive Accounting for Casinos & Gaming
the payback period is called the payback method. The payback period is Accounting for Inventory
expressed in years and fractions of years. For example, if a company Accounting for Managers
Accounting Information Systems
invests $300,000 in a new production line, and the production line then
Accounting Procedures Guidebook
produces positive cash flow of $100,000 per year, then the payback
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period is 3.0 years ($300,000 initial investment ÷ $100,000 annual Bookkeeping Guidebook
payback). Budgeting
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Closing the Books
The formula for the payback method is simplistic: Divide the cash outlay
Construction Accounting
(which is assumed to occur entirely at the beginning of the project) by the
Cost Accounting Fundamentals
amount of net cash inflow generated by the project per year (which is Cost Accounting Textbook
assumed to be the same in every year). Credit & Collections
Fixed Asset Accounting
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Payback Period Example
GAAP Guidebook
Governmental Accounting
Alaskan Lumber is considering the purchase of a band saw that costs Health Care Accounting
$50,000 and which will generate $10,000 per year of net cash flow. The Hospitality Accounting
payback period for this capital investment is 5.0 years. Alaskan is also IFRS Guidebook
Lean Accounting Guidebook
considering the purchase of a conveyor system for $36,000, which will New Controller Guidebook
reduce sawmill transport costs by $12,000 per year. The payback period Nonprofit Accounting
Oil & Gas Accounting
for this capital investment is 3.0 years. If Alaskan only has sufficient funds
Payables Management
to invest in one of these projects, and if it were only using the payback Payroll Management
method as the basis for its investment decision, it would buy the conveyor Public Company Accounting
system, since it has a shorter payback period. Real Estate Accounting
Small Audit Practice Set

Payback Method Advantages and Disadvantages

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Business Ratios Guidebook
The payback period is useful from a risk analysis perspective, since it Corporate Cash Management
gives a quick picture of the amount of time that the initial investment will Corporate Finance
be at risk. If you were to analyze a prospective investment using the Cost Management
payback method, you would tend to accept those investments having Enterprise Risk Management
Financial Analysis
rapid payback periods and reject those having longer ones. It tends to be
Interpretation of Financials
more useful in industries where investments become obsolete very Investor Relations Guidebook
quickly, and where a full return of the initial investment is therefore a MBA Guidebook
serious concern. Though the payback method is widely used due to its Mergers & Acquisitions
simplicity, it suffers from the following problems: Treasurer's Guidebook

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1. Asset life span. If an asset’s useful life expires immediately after it
Constraint Management
pays back the initial investment, then there is no opportunity to Human Resources Guidebook
generate additional cash flows. The payback method does not Inventory Management
incorporate any assumption regarding asset life span. New Manager Guidebook
Project Management
2. Additional cash flows. The concept does not consider the presence Purchasing Guidebook
of any additional cash flows that may arise from an investment in the
periods after full payback has been achieved. Send us your e-mail address
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3. Cash flow complexity. The formula is too simplistic to account for discounts *
the multitude of cash flows that actually arise with a capital
investment. For example, cash investments may be required at
several stages, such as cash outlays for periodic upgrades. Also,
cash outflows may change significantly over time, varying with
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customer demand and the amount of competition.

4. Profitability. The payback method focuses solely upon the time

required to pay back the initial investment; it does not track the
ultimate profitability of a project at all. Thus, the method may
indicate that a project having a short payback but with no overall
profitability is a better investment than a project requiring a long-
term payback but having substantial long-term profitability.
5. Time value of money. The method does not take into account the
time value of money, where cash generated in later periods is worth
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. Other capital budgeting analysis methods that
include the time value of money are the net present value method
and the internal rate of return.

6. Individual asset orientation. Many 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.
7. Incorrect averaging. The denominator of the calculation is based on
the average cash flows from the project 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.

Payback Method Example #2

ABC International has received a proposal from a manager, asking to

spend $1,500,000 on equipment that will result in cash inflows in
accordance with the following table:

Year Cash Flow

1 +$150,000
2 +150,000
3 +200,000
4 +600,000
5 +900,000

The total cash flows over the five-year period are projected to be
$2,000,000, which is an average of $400,000 per year. When divided
into the $1,500,000 original investment, this results in a payback period of
3.75 years. However, the briefest perusal of the projected cash flows
reveals that the flows are heavily weighted toward the far end of the time
period, so the results of this calculation cannot be correct.

Instead, the company's financial analyst runs the calculation year by year,
deducting the cash flows in each successive year from the remaining
investment. The results of this calculation are:
Year Cash Flow Net Invested Cash

0 -$1,500,000

1 +$150,000 -1,350,000

2 +150,000 -1,200,000

3 +200,000 -1,000,000

4 +600,000 -400,000

5 +900,000 0

The table indicates that the real payback period is located somewhere
between Year 4 and Year 5. There is $400,000 of investment yet to be
paid back at the end of Year 4, and there is $900,000 of cash flow
projected for Year 5. The analyst assumes the same monthly amount of
cash flow in Year 5, which means that he can estimate final payback as
being just short of 4.5 years.

Summary

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 lower-cost and lower-capacity units would make more
sense than an expensive "monument" asset.

Similar Terms

The payback period formula is also known as the payback method.

Related Courses

Capital Budgeting
Financial Analysis

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