The Payback Period

The payback period is the time length in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. The payback period of a given investment or project is a significant determinant of whether to accept the project, as shorter payback periods are commonly desirable for investment positions.

The payback period gives information about the amount of time that a firm needs to recover its initial investment in a capital budgeting proposal. It provides a kind of break-even measure. Such information might be important where economic situations change and the firm may have to discard a project. It also serves as a basic measure of liquidity and project risk. It is used from short term period. It does not consider time value of money.

It uses maximum payback period as the measure of figuring out whether a project is acceptable. In general, shorter payback periods are better than longer payback periods. For independent projects, the decision rule is to accept all projects with a payback period less than or equal to cutoff period specified by a decision maker. If projects are mutually exclusive, the decision rule is to accept the project with the shortest payback period only when the payback period is less than or equal to the maximum payback period.

The payback period is very useful in evaluating projects because it is intuitive, easy to compute and easy to understand. The payback period provides some information on the risk of the investment because near cash flows are generally less risky than distant cash flows.

 The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. If the projects are even, the formula to calculate payback period is:

Payback Period = Initial cash outflow / Average CFAT

Let’s consider a Company is planning to undertake a project requiring initial investment of $100million. The project is expected to generate $20 million per year for 6 years.  

Then payback period of the project can be calculated as:

Payback Period = Initial cash outflow / Average CFAT = 100/20 = 5 years

Similarly if the cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:

Payback Period = Year before full recovery + Amount to be recovered/ CFAT for recovered year