Payback analysis is a very simple method to determine the financial feasibility of an investment project. The main question of a Payback Analysis is the following:
- How long will it take to recover the investment?
The best projects take a short time to recover their investment, mostly 1 to 2 years, while other projects will require 5 or more years. The best thing about this analysis is, it is easy to calculate, simple to understand and it focuses on cash flow. It, therefore, offers a solid basis for making important financial decisions under time pressure.
What we observe is that fact that still many companies simply forget that this analysis would exist. They evaluate important investment projects by simply comparing profits on the P&L at the best with the excuse that it takes too much time to perform a more sophisticated analysis. In many cases, there is neither an IRR (Internal Rate of Return) nor DCF (Discounted Cash Flow) analysis performed and the decision sometimes has inherent methodological flaws in it. Another important point is that very often decisions are not focused enough on cash flow and exclude net working capital and even CAPEX in some cases. The consequence of this mishap is that precious capital will be misallocated. In other words, the company ending up investing in bad projects which fail to deliver an adequate return. The point is, Payback analysis is simple, easy to understand and can offer a quick solution.
How does Payback Analysis Works?
As mentioned before, Payback Analysis works on the basis of the cash flows of a project. It is very simple as all you want to know is how many years it takes until your investment is repaid. There are two ways to calculate the payback period. Projects with Even cash flows which you calculate by simply dividing the initial investment by the cash inflow per period. And Projects with Uneven cash flows which you calculate by subtracting the cash flows from the initial investment until the initial investment is covered.
Let’s say, for example, you are presented with Project A where the initial investment is $50M and assuming the project is expected to constantly get $25M each year. Using the formula to calculate an Even Cash Flow, the payback period is in 2 years. For the next project, Project B, we’ll assume the same initial investment but with uneven cash flows over 5 years this time. To make sure to get the precise payback period, we will need to determine the missing cash flow by the end of year 3 by the cash flow received in year 4. This is easily calculated using the formula: Payback Period = 3 + (11/19) = 3.6 years. Therefore, the payback period for Project B is 3.6 years. And for the last case, Project C, with the same initial investment but with a different set of Uneven Cash Flows over 5 years. The same payback period calculation method for uneven cash flows is used, hence, the resulting payback period for Project C is = 4 + (10/20) = 4.5 years.
According to the illustration, there are three variables that you need to take note of to calculate the payback period. First is the last period with negative cash flow; second, the absolute value of the last negative cumulative cash flow; and lastly, the total cash flow received after the period with negative cash flow. Simply knowing these three will let you know at which point the payback period is.
Making Financial Decisions with Payback Analysis
Now let’s compare the three projects A, B, and C by looking comparing their Payback periods:
- Project A shows a Payback period of 2.0 years
- Project B shows a Payback period of 3.6 years
- Project c shows a Payback period of 4.5 years
Now the question is very simple? In which project would you invest your money? -The answer is Project A.
Obviously, now that you know which project takes less time to return your initial investment, you can use that information for your decision making. In this case, the best choice would be Project A, with the least amount of years to pay off the initial amount invested. The lesser time needed to return the initial investment, the lesser the investment will be at risk since it can be quite common sometimes a business case fails to push through before reaching the payback period. As a result, the concern of knowing when the initial investment will be paid back completely is critical as well as for deciding upon choosing shorter payback periods and rejecting projects with longer payback periods offers great help in financial decision-making.
Does Payback Analysis have some weaknesses? – Yes of course. Payback Analysis does not consider the returns after the investment is paid pack and is biased more towards the time of the investment. If Project C would have a huge return in year 8, this would not be considered in Payback analysis. However, this can be addressed in a very simple way that one should also as himself the question of what return potential has not been considered and how big this would be? – In case the answer is the return potential appears significant, this would be an indication to even also look at IRR and NPV analysis.
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