What is Payback Period?
The concept of the payback period is clear for capital budgeting purposes. The payback period reflects the amount of years it takes to repay a capital project’s initial investment from the cash flows generated by the project.
The payback period method in capital budgeting is the selection criterion, or the key factor, on which most organizations depend to choose among possible capital projects. Small and large companies tend to concentrate on ventures with a chance of quicker, more attractive payback. To measure a capital project’s payback period, analysts weigh project cash flows, initial expenditure, and other variables.
What is Payback Analysis?
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 do you calculate your Payback Period?
Here’s a payback period example to know when you get your money back.
Company ABC is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million net cash flow in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Answer: Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years
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. So here’s a payback period example.
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.
What are the Advantages of Calculating the Payback Period?
Here are few of the most common advantages of knowing you payback period:
- Easy to Calculate – The idea of a Payback Period is incredibly easy to comprehend and to quantify. The payback period will probably be measured without even using a calculator or electronic spreadsheet while engaging in a rough review of a project proposal.
- Risk Indicator – The analysis focuses on how easily money from an investment can be recovered, which is basically a risk indicator. Thus, to evaluate the relative risk of projects with different payback periods, the payback period can be used.
- Highlights short-term liquidity – Since this approach favors ventures that rapidly return money, investments with a greater level of short-term liquidity tend to result.
- Applicable for Limited investments – For projects with limited investments, the payback period method is acceptable. In such programs, it is not worth wasting much time and money on sophisticated economic analysis.
- ROI-based results – The payback period would be able to demonstrate exactly which investment, which should make the decision easier, is going to be better based on ROI. If there is not anything else to distinguish between various projects, a manager would need all the data to help him/her make a choice.
- Long-term campaigns – In order to get their money back as soon as they can, not every company would want to invest in the short term. Investment is also a long-term campaign, and managers will be shown how a specific project will possibly pay off over time by the payback period process.
- Analyze projects better – There may be endless possibilities for acquisitions and various ventures depending on the type of company being managed. If you use the system of payback duration, it will give you a basic understanding of how the projects perform so that you can pick the right ones.
- Minimum Loss – A business stockholder is able to realize what investments are likely to be less costly and have a shorter time to break even with the payback period process, so this chance of major losses would be at a minimum.
Although there is no optimal way to administer a company’s accounting, investments, and budgeting, there are definitely certain strategies that are going to be much better than others. In some industries with short-term growth, the payback period approach does have some validity, but there are too many considerations that need to be weighed for most companies to be a go-to method.
What are the disadvantages of the Payback period
Despite of the great advantages of Payback Period, it also have a couple of disadvantages below:
1. Focus only on the payback period.
For a payback period strategy, there are some very major problems to observe, the first is that it only looks at cash flow over a certain period of time. This is fine if a company is only trying to see how easily they can break even on their investment, but that is definitely not always the case.
2. Short-term budgets with emphasis.
Together with the idea that the scores for the payback period focus only on the investment’s initial return, it is a concentrated budgeting strategy that is naturally short-term. If your organization is looking for a longer-term approach to project investment, there are some big weaknesses in the payback period process.
3. It doesn’t look at Investment Time Value.
This budgeting strategy focuses solely on short-term cash flow and the quickest possible return, so a lot of other factors are lacking. Over time, the value of money can differ, especially when you talk about stable, long-term investments.
4. Calculation is not realistic
For most companies, the dilemma is that they need to have a better mix of ventures and investments in order to take care of both their short, mid and long-term needs. If they want to have a prosperous future ahead, no organization will be able to rely on this technique for their investment opportunities. Using a variety of approaches to make substantial choices is often easier.
Making Financial Decisions based on Payback Analysis
Now let’s compare the three projects A, B, and C by looking comparing the payback period example above:
- 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.
How does Payback Analysis compare to other Financial Metrics?
This section will explain the comparisons between a couple of financial metrics and the Payback Method.
Payback Method versus NPV
Here are some of the difference between the payback method and NPV:
- NPV (Net Present Value) is calculated in terms of currency, while the payback method relates to the amount of time taken to repay the total initial investment in order to return the investment.
- As the time value of resources, inflation, risk, financing or other significant variables are not adequately accounted for, the payback approach has restrictions on its use. The NPV strategy takes time value into account and gives the business’s owners a simple measure of the dollar benefit on the project’s present value basis.
- NPV demands the use of a discount rate that can be hard to determine, while discount rates are not used.
- The present value of potential cash flows is also neglected by the PB system. The current value of potential cash flows is determined by NPV.
- Payback lacks the incentives that emerge during payback time. It does not measure total revenue either. An inherent assumption in the use of the payback period is that the returns on the investment continue beyond the payback period.
Payback Method versus IRR
Here are some of the difference between the payback method and IRR:
- We express PB in the form of a time period, whereas in the form of percentage returns, IRR is expressed.
- IRR focuses on assessing the breakeven rate at which, while PB has a different objective, the present value of the potential cash flows becomes null.
- IRR does not have this problem since the rate of return is calculated.
- Both of them neglect the current value of future cash flows.
Payback Method versus ROI
Here are some of the difference between the payback method and ROI:
- The payback period of an investment is the number of years it takes to break-even/recoup/recover the amount of money you initially invested. Return on investment, on the other hand, gives you the amount of money you would get in return as a result of your investment.
- Simple ROI is the incremental gains of an action divided by the cost of the action. This metric will predict the percentage or ratio of gains to cost. You will hear ROI given as a number, usually a percentage.
- The problem with looking at simple ROI alone is that this tells you nothing about time, while PB in the form of a time period.
- The calculation of PB is more cumbersome than that of simple ROI. Payback period analysis does not tell the whole story. What are the gains once the investment has paid for itself? Payback period doesn’t calculate this information.
Payback Method versus ARR
- We express ARR in the form of a percentage, while PB in the form of a time period.
- ARR is focused on determining the percentage returns from an investment, while the PB focuses on the time when to recover the investment.
- ARR does not have the difficulty of ascertaining an appropriate discount rate.
- Both of them neglect the current value of future cash flows.
When to Use Payback Analysis?
Organizations normally have an option of multiple projects to pursue, each with its own benefits and drawbacks. The payback period can be used as a decision-making tool when all other variables are equal, since a fast payback period can easily flow into the cash flow and balance sheet of the company.
For the reasonably typical case, where a significant upfront investment produces a steady return over time, the payback period is an ideal metric. This return is usually followed by a significant amount of project risk. The market risk of making the investment would also be mitigated by a fast payback period.
As an analysis tool, Payback period is mostly used because for most people it is easy to apply and easy to understand, regardless of formal training or area of endeavor. It can be very useful when used carefully or to compare related investments. Shorter payback periods are superior to longer payback periods, all things being equal. As a stand-alone tool for contrasting an investment, the payback period has no clear decision-making requirements (except, perhaps, that the payback period should be less than infinity).
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We hope this article was useful. eFinancialModels provides a wide variety of industry-specific financial model templates created by skilled financial modelers. Our financial models are used by Entrepreneurs, Startups, SMEs, Financial Consultants for financial decision-making on a daily basis. Our authors also provide custom financial modeling services to help those who need assistance with their financial modeling tasks.