Payback Method
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Introduction
• The time required to earn back the amount invested in an
asset from its net cash flows.
• It is a simple way to evaluate the risk associated with a
proposed project.
• An investment with a shorter payback period is considered
to be better, since the investor's initial outlay is at risk for
a shorter period of time.
How to calculate Payback
• Divide the cash outlay (which is assumed to occur entirely
at the beginning of the project) by the amount of net cash
inflow generated by the project per year (which is
assumed to be the same in every year).
Example of Payback
• ABC International has received a proposal from a
manager, asking to spend $1,500,000 on equipment that
will result in cash inflows in accordance with the following
table: Year Cash Flow
1 +$150,000
2 +150,000
3 +200,000
4 +600,000
5 +900,000
Continue Example
Year Cash Flow Net
Invested
Cash
0 -
$1,500,000
1 +$150,000 -1,350,000
2 +150,000 -1,200,000 The table indicates that the real payback period is located
somewhere between Year 4 and Year 5. There is $400,000 of
3 +200,000 -1,000,000 investment yet to be paid back at the end of Year 4, and there is
4 +600,000 -400,000 $900,000 of cash flow projected for Year 5. The analyst assumes
the same monthly amount of cash flow in Year 5, which means
5 +900,000 0 that he can estimate final payback as being just short of 4.4 (4.5)
years.
Payback Method Advantages
and Disadvantages
• Asset life span. If an asset’s useful life expires immediately after it pays back the
initial investment, then there is no opportunity to generate additional cash flows.
The payback method does not incorporate any assumption regarding asset life
span.
• Additional cash flows. The concept does not consider the presence of any
additional cash flows that may arise from an investment in the periods after full
payback has been achieved.
• Cash flow complexity. The formula is too simplistic to account for the multitude of
cash flows that actually arise with a capital investment. For example, cash
investments may be required at several stages, such as cash outlays for periodic
upgrades. Also, cash outflows may change significantly over time, varying with
customer demand and the amount of competition.
Payback Method Advantages
and Disadvantages
• Profitability. The payback method focuses solely upon the time required to pay back the initial
investment; it does not track the ultimate profitability of a project at all. Thus, the method may
indicate that a project having a short payback but with no overall profitability is a better investment
than a project requiring a long-term payback but having substantial long-term profitability.
• Time value of money. The method does not take into account the time value of money, where cash
generated in later periods is worth less than cash earned in the current period. A variation on the
payback period formula, known as the discounted payback formula, eliminates this concern by
incorporating the time value of money into the calculation. Other capital budgeting analysis methods
that include the time value of money are the net present value method and the internal rate of return.
• Individual asset orientation. Many fixed asset purchases are designed to improve the efficiency of a
single operation, which is completely useless if there is a process bottleneck located downstream
from that operation that restricts the ability of the business to generate more output. The payback
period formula does not account for the output of the entire system, only a specific operation. Thus,
its use is more at the tactical level than at the strategic level.
Payback Method Advantages
and Disadvantages
• Incorrect averaging. The denominator of the calculation is
based on the average cash flows from the project over
several years - but if the forecasted cash flows are mostly
in the part of the forecast furthest in the future, the
calculation will incorrectly yield a payback period that is
too soon. The following example illustrates the problem.
Summary
The payback method should not be used as the sole criterion for approval
of a capital investment.
Instead, consider using the net present value or internal rate of return
methods to incorporate the time value of money and more complex cash
flows, and use throughput analysis to see if the investment will actually
boost overall corporate profitability.
There are also other considerations in a capital investment decision, such
as whether the same asset model should be purchased in volume to
reduce maintenance costs, and whether lower-cost and lower-capacity
units would make more sense than an expensive "monument" asset.