Payback Period

What Does Payback Period Mean?
The length of time required to recover the cost of an investment.

Calculated as:

Investopedia explains Payback Period
All other things being equal, the better investment is the one with the shorter payback period.

For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000 / $20,000, or five years.

There are two main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred.