What Is the Payback Period?
The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a breakeven point.
The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.
[Important: Investors and managers can use the payback period to make quick judgments on their investments.]
The concept of the payback period is generally used in financial and capital budgeting. But it has also been used to determine the cost savings of energy efficiency technology.
Understanding Payback Periods
Corporate finance is all about capital budgeting. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects. The analyst must find a reliable way to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period.
The payback period is the cost of the investment divided by the annual cash flow. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period.
But there is one problem with the payback period. It ignores the time value of money (TVM), unlike other methods of capital budgeting such as net present value (NPV), internal rate of return (IRR), and discounted cash flow.
While payback periods are useful in financial and capital budgeting, it has applications in other industries. It can be used by homeowners and businesses to calculate the return on the energy efficient technologies such as solar panels and insulation, as well as maintenance and upgrades.
Capital Budgeting and the Payback Period
Most capital budgeting formulas take the time value of money (TVM) into consideration. This is the idea that money today is worth more than the same amount in the future due to the present money's earnings potential. Therefore, if you pay an investor tomorrow, it must include an opportunity cost. The time value of money is a concept that assigns a value to this opportunity cost.
The payback period, though, disregards the time value of money. It is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of the investment, the payback period is five years. Some analysts favor the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.
The payback period does not account for what happens after payback, ignoring the overall profitability of an investment. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time.
- The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to hit breakeven.
- Account and fund managers use the payback period to determine whether to go through with an investment.
- Shorter paybacks mean more attractive investments while longer payback periods are less desirable.
- The payback period is calculated by dividing the amount of the investment by the annual cash flow.
Example of Payback Period
Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. The payback period for this investment is four years—dividing $1 million by $250,000. Consider another project that costs $200,000 with no associated cash savings will make the company an incremental $100,000 each year for the next 20 years at $2 million. Clearly, the second project can make the company twice as much money, but how long will it take to pay the investment back?
The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back and the company's earnings potential is greater. Based solely on the payback period method, the second project is a better investment.