What is the Payback Period
The payback period is 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. The payback period 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.
BREAKING DOWN Payback Period
Much of corporate finance is about capital budgeting. One of the most important concepts that 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.
Capital Budgeting and the Payback Period
Most capital budgeting formulas take the time value of money into consideration. The time value of money (TVM) is the idea that money today is worth more than the same amount in the future due to 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 disregards the time value of money. Simply, 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.
Payback Period Example
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 4 years, which is found by dividing $1 million by $250,000. Consider another project that costs $200,000, has no associated cash savings, but will make the company an incremental $100,000 each year for the next 20 years ($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 2 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.