The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it's how long it takes for the cash flow of income from the investment to equal its initial cost. This is usually expressed in years.
Most of what happens in corporate finance involves capital budgeting — especially when it comes to the values of investments. Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting.
Payback Period Analysis
Payback period analysis is favored for its simplicity, and can be calculated using this easy formula:
Payback Period = Initial Investment ÷ Estimated Annual Cash Flow
This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time.
When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment.
Some companies rely heavily on payback period analysis and only consider investments for which the payback period does not exceed a specified number of years. So, longer investment periods are typically not desired.
Limitations of Payback Period Analysis
Despite its appeal, the payback period analysis method has some significant drawbacks. The first is that it fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day's earning potential.
Thus, an inflow return of $15,000 from an investment that occurs in the fifth year following the investment is viewed as having the same value as a $15,000 cash outflow that occurred in the year the investment was made despite the fact the purchasing power of $15,000 is likely significantly lower after five years.
Furthermore, the payback analysis fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another. For example, two proposed investments may have similar payback periods. But cash inflows from one project might steadily decline following the end of the payback period, while cash inflows from the other project might steadily increase for several years after the end of the payback period. Since many capital investments provide investment returns over a period of many years, this can be an important consideration.
The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.
This method also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments.
Due to its limitations, payback period analysis is sometimes used as a preliminary evaluation, and then supplemented with other evaluations, such as net present value (NPV) analysis or the internal rate of return (IRR).
The Bottom Line
The payback period can be a valuable tool for analysis when used properly to determine whether a business should undertake a particular investment. However, this method does not take into account several key factors including the time value of money, any risk involved with the investment or financing. For this reason, it is suggested that corporations use this method in conjunction with others to help make sound decisions about their investments.