The Payback Period is a method used in Capital Budgeting to compare alternative capital investment decisions and make final decisions on which projects should be accepted and rejected based upon reaching their respective paybacks.
To determine how long it will take for an investment to earn an amount sufficient to recover all costs, i.e., its cost of capital, simply divide the total cost by annual net profit or cash flow. The resulting number is the Payback Period in years. The project may be accepted if the calculated period is less than a specified minimum acceptable period, say three years. And if it is more than twice that value, say six years, it should be rejected.
The payback method provides only limited information about an investment’s attractiveness. It ignores whether or not funds must be borrowed to make the initial outlay on a new capital asset and how much will have to be repaid after the payback period ends, as well as how long it will take to recoup any additional outlays of cash from operating assets once they are purchased.
Many other factors also affect a firm’s willingness to borrow money or invest its funds in some particular capital asset, such as the time value of money, risk, and inflation.
The payback period calculates the number of years required for initial capital investment to recover its cost from cash inflows from the project being considered. The payback period is not a complete evaluation method because it does not include an estimate of profit beyond the payback period, which is very important in determining whether a project should be accepted or not. In addition, it provides no information about how much cash will be returned if the project requires additional investments after the initial one.
The payback method is a simple analysis of the cash flows involved in an investment and the time required for the periodic net cash inflows or outflows to recover the original cost or earn a specified rate of return, such as the firm’s cost capital.
A project with a favorable payback period is acceptable; one with negative paybacks is not. If multiple independent projects must be considered together, then only those with positive net present value should be accepted due to lack of funds. The payback method ignores the time value of money and future tax consequences, both of which are important in determining a project’s desirability.
The payback period is a measure that calculates the length of time required to recover an investment from net cash receipts based on expected values for each period. The rate used to calculate the value of each receipt must be equal to, or greater than, the firm’s required return on its investments.
This is because the company only has an incentive to invest in any given project if it can generate sufficient returns over time, at least equal to its cost of capital. If this is not true, it would be more profitable to simply purchase a security that meets this requirement rather than investing in the long-term project.
What Can Affect a Payback Period?
To reach a two-year payback period, your project would need to generate $900 in additional annual revenue every year after the initial investment. That looks pretty good on paper, but several factors could cause this project not to live up to expectations:
1. Failure To Meet Projected Revenue:
If you estimate incorrectly or plans change after breaking ground on a project, then your income projections could be off by a wide margin. In our example above, if your new capital budgeting idea produced an additional $600 instead of $900, then it would take your company three full years to break even on this project. This is a common problem with capital budgeting – and one reason why companies should focus more heavily on return instead of the payback period alone.
2. Inflation:
Any time you deal with constantly changing numbers in the market, inflation is often part of the equation. Let’s say that after completing your initial revenue projection for this project, your best estimate is that there will be 3% annual inflation over five years – meaning that every year things will become 3% more expensive while also adding 3% to your income projections. Do some quick math, and you’ll see that by Year 5, your assumptions for additional revenue are off by nearly 30%. This is why inflation must be considered when projecting future yields on a project.
3. Poor Operation:
Your business may simply be unable to hold up its end of the bargain by utilizing this potential capital budgeting project as efficiently as possible. For example, if you underestimated costs, it could cause your bottom line to shrink with each passing year. Perhaps you overestimated how many clients would sign on at the outset and therefore had to hire more employees than initially anticipated – driving up operating expenses and ultimately reducing margins on your revenue growth projections.
These kinds of problems can derail even previously successful projects and ideas that seemed like sure bets at first glance. However, by using the pay period calculation we’ve outlined above, you can better understand such capital budgeting problems and know what you’re looking for when it comes to additional metrics like the net present value, internal rate of return, and other calculations that take your overall risk into account.
Importance of the payback period
Following are some pointers that showcase why the payback period is crucial in any organization.
- It helps decide whether to go ahead with a project.
- The cost of capital can be reduced by computing the payback period so that the debt/equity ratio would increase, increasing the return on equity, return on assets, and the net present value of stocks/bonds.
- The risk associated with projects can be assessed by computing the payback period, as this is one of the common factors used for comparing risky investments.
- A company’s management should benchmark its performance vis-à-vis others’ performance within the industry through the computation of various ratios, including payback period, internal rate of return (IRR), net present value (NPV), etc.
- It helps decide the length of time for raising funds or obtaining loans.
Points to remember if you are just starting to use the payback period calculation:
– Ignore sunk costs and start by looking at expected future returns. Once you begin to understand the value of your invested capital, you will be well on your way to better investments for your firm.
– Accounts receivable and inventory should not be included in this calculation because they do not represent “funded” capital – i.e., there is little chance that it will be returned to you as a result of the investment.
– The payback period does not consider any potential opportunity costs associated with investing money into one project or another, so it should only serve as the first step in determining whether or not an investment is worth pursuing.
Wrapping Up:
The payback period is a simple calculation that uses net present value and future cash flow projections to determine the length of time it will take for your investment – in whatever form that may take – to break even. This metric is popular among companies because it essentially boils down an idea’s potential profitability into a quick and easy-to-understand number, whether it be two years or ten.
However, too much weight should not be given to this figure alone because many other factors are involved when deciding where to invest company resources. But since both investors and managers must constantly make decisions based on what they know today, the payback period calculation has its place in determining which projects might have long-term potential.
