A method of capital budgeting in which the time required before the projected cash inflows for a project equal the investment expenditure is calculated; this time is compared to a required payback period to determine whether or not the project should be considered for approval. If the projected cash inflows are constant annual sums, after an initial capital investment the following formula may be used:payback (years) = initial capital investment/annual cash inflow.
payback (years) = initial capital investment/annual cash inflow.
Otherwise, the annual cash inflows are accumulated and the year determined when the cumulative inflows equal the investment expenditure. The method is sometimes seen as a measure of the risk involved in the project.
The two major weaknesses of the payback method are:• the time value of money is not considered;• the cash flows after the investment is recovered are not considered.
• the time value of money is not considered;
• the cash flows after the investment is recovered are not considered.
However, payback is a relatively simple technique for managers to use and for this reason it remains popular. Often managers use payback and discounted cash flow techniques at the same time, even though they are very different methods of capital budgeting (see discounted payback method).
EXAMPLE
A hospital is considering the purchase of a new X-ray machine for £50,000. The annual cash savings from the new machine are estimated at £20,000.payback = initial capital investment/annual cash inflowspayback = £50,000/£20,000 = 2.5
payback = initial capital investment/annual cash inflows
payback = £50,000/£20,000 = 2.5
The hospital will therefore recover its investment in 2.5 years. On this basis, it is difficult to say whether the hospital should buy the new machine. Most managers would see a payback period of less than 3 years as good.
FAQs
In simple terms, the payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash flow is positive, which is the payback year. Payback period is generally expressed in years.
What question is the payback period model answering? ›
The payback method evaluates how long it will take to “pay back” or recover the initial investment. The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflow(s) for the investment.
What is the main problem with the payback method? ›
Payback ignores the time value of money. Payback ignores cash flows beyond the payback period, thereby ignoring the "profitability" of a project. To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.
What are the limitations of pay back period method? ›
Limitations of Payback Period Analysis
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.
What is the payback period method in simple words? ›
Payback period is defined as the number of years required to recover the original cash investment. In other words, it is the period of time at the end of which a machine, facility, or other investment has produced sufficient net revenue to recover its investment costs.
Do you want a shorter payback period? ›
Ideally, the shortest possible payback period should be your go-to option. As you obtain a swift recovery of the original cost of investment, the project is likely to be deemed successful. It should also be noted, however, that all investments and projects cannot be achieved within the same time horizon.
What does the payback period model fail to consider? ›
Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project's process.
How do I calculate payback period in Excel? ›
First, input the initial investment into a cell (e.g., A3). Then, enter the annual cash flow into another (e.g., A4). To calculate the payback period, enter the following formula in an empty cell: "=A3/A4" as the payback period is calculated by dividing the initial investment by the annual cash inflow.
What are the pros and cons of payback period method? ›
The main advantages of Pay-back Period Method include its simplicity, ability to manage liquidity, risk assessment, and use as a planning tool. The primary disadvantages are its ignorance of profitability beyond the payback period, disregard of the time value of money, and subjective nature.
What is one weakness of the payback method of project analysis? ›
Transcribed image text: A weakness of the payback method of project evaluation is that it: O fails to take account of the magnitude and timing of the cash flows.
The most significant advantage of the payback method is its simplicity. It's an easy way to compare several projects and then to take the project that has the shortest payback time.
What is a major disadvantage of the discounted payback period method? ›
If the discounted payback period of a project is longer than its useful life, the company should reject the project. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period.
What is one disadvantage of the payback period method it ignores the time value of money? ›
Answer and Explanation:
The statement is true. The calculation of payback period takes into account all the cash flows of a project, but it does not discount them to the present value (in other words, it does not consider the time value of money).
What is the disadvantage of a payback period quizlet? ›
Ignores cash flows beyond the payback period.
How do you use payback period in a sentence? ›
payback period | Business English
the time taken to get back the amount originally invested in something: Investors will see a swift return, with a payback period of between a year and 18 months.
What is the difference between ROI and payback period? ›
ROI (Return on Investment) estimates the potential return of a business, product, or service. Payback, on the other hand, is related to the return time of an investment, that is, the time it will take for the profit to equal the invested amount.
Does payback period include depreciation? ›
From the definition, it can be seen that only cash flows should be included within the calculation – specifically, only relevant cash flows should be included within the calculation, so items such as depreciation should be excluded.
What is a payback period quizlet? ›
Payback period. Refers to the amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment. Payback period equation.
