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What is the payback period?
The payback period for a project is the amount of time required to recover the project’s initial investment. It answers the question: How soon will I recover my initial investment?
The payback period formula, assuming projects has the same cash flows every year, is:
The payback period formula assumes that there is:
- Initial investment: An initial outflow of cash investment at the beginning of the project
- Future cash flows: A series of cash flows generated in the future by the project
It then asks the question, after how many years will my investment breakeven?
Let's look at an example.
I invested $1 million into a sandwich shop. Every year, the sandwich shop will generate $250,000. What is the payback period?
Let's use the payback period formula:
Payback period = Initial investment / Annual cash flow
Payback period = $1,000,000 / $250,000 per year
Payback period = 4 years
You will recover your initial investment of $1 million in 4 years.
The cash flows from the project are in the table and graph below.
The net invested cash is the cumulative cash flow less the initial investment.
Net invested cash = Cumulative cash flow - initial investment
We have reached the payback period or breakeven point when this is $0.
|Year||Cash flow||Net invested cash|
How to calculate payback period
There are some variations in how you calculate the payback period.
Constant future cash flows
If the future cash flows of the project will be the same very year, then the payback period formula is:
Understanding payback periods
Payback periods are used by companies to evaluation possible investments. Companies use a payback period rule to determine if they should invest in a project.
How is the maximum acceptable payback period determined?
The company decides what the maximum acceptable payback period is. There is no hard and fast rule. It can be influenced by how long the product life cycle is or the economic climate.
Advantages and disadvantages of using the payback period rule
There are advantages and disadvantages of using the payback period rule.
The payback period rule is popular because it is very simple to calculate and understand. It feels intuitive.
However, it has many shortcomings and should not be the only metric used to decide whether to invest in a project.
- Simple to calculate.
- Easy to understand.
- Provides some information on the risk of the investment.
- Time value of money
Ignores the time value of money.
- Long-term cash flows
Cash flows after the breakeven point are ignored. The payback period rule is biased against projects with a long period of future cash flows.
The payback period rule emphasizes short-term cash flows.
- Uneven cash flows
Projects with small cash flows in the early years and big cash flows in later years are penalized.
- Payback period cut-off
There is no hard rule on how many years or months is a good cut-off point for deciding whether a project will take too long. This time horizon is subjectively determined and there is no basis in economic theory.
The cut-off point can also vary over time. It tends to be shorter during recessions and tougher economic climates.
- Additional investments
The payback period formula assumes no additional investments are required. All the investment is at the beginning. This may not reflect reality.
Profitability is ignored. Two projects that have the same cash flows but very different profit margins would be treated the same under the payback period formula.
Good projects that would be rejected under the payback period rule
Pharmaceutical development is an example of projects that would be rejected under the payback period rule, but could be good investments.
It can take at least 10 years fora drug to complete the journey from the initial discovery phase to clinical trials and to being marketed. This process can cost hundreds to millions to billions according to PHRMA. This investment cannot be recovered within a few years, but drugs that go on to become blockbusters can create huge value for companies. For example, the popular allergy drug Claritin has revenues of $2.6 billion in 2000, before it went generic.
Why is the payback period rule used?
Given the disadvantages of the payback period method, why and how is it used?
The payback period method is very easy to calculate and can be an easy shortcut when evaluating a lot of projects. It can be used as a ‘reality check’ before deciding to spend more time on analyzing the project and calculating other ROI metrics.
The method can help answer the question, “Should we investigate further into this project?”
Using the payback period method to evaluate small projects
The payback period method is more often used for small-dollar decisions. As a result, it is used by small firms more often than large firms and by large firms only for small projects. For example, a company might have a rule that requires all projects with an initial investment of $20,000 or less to have a payback period of 2 years or less.
Future cash flows are hard to estimate
While one of the shortcomings of the payback method is that it ignores cash flows that are way into the future, the counter argument is that future cash flows on small projects may be too hard to estimate anyway. They can also be time consuming to estimate.
Short-term cash flows can be estimates more accurately and more easily.
Focusing on the short-term also removes some of the risk of the long-term. For example, the economic climate could change, new competitors could enter the industry, and technology could change.
The payback period method is a good first screen.
Time value of money
However, the payback method still ignores the time value of money. We can take this into account by adding discounting to our future cash flows.
Discounted payback period
The discounted payback period method fixes the problem of ignoring the time value of money.
Future cash flows are adjusted and restated in current dollars by using a discount rate.
Alternatives to the payback period rule
While the discounted payback period adjusts for the time value of money, it is still flawed.
It ignores future cash flows after the initial investment has been recovered. But this future cash flow is very important to determining whether a project should be funded.
To take this into account, we should use a discounted cash flow model that includes all future cash flow - this is the net present value method.