Payback Period

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DEFINITION of 'Payback Period'

The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

Calculated as:

Payback Period = Cost of Project / Annual Cash Inflows

 

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BREAKING DOWN '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.

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