See Also:
Bailout Payback Method
Capital Budgeting Methods
NPV vs Payback Method
Payback Period Method Explanation
Payback period shows the length of time required to repay the total initial investment through investment cash flows. A project is acceptable if its payback period is shorter than or equal to the cutoff period.
Payback Period Formula
Payback period = Initial investment ÷ Cash flow per year
Calculation
For example, a company invested $20,000 for a project and expected $5,000 cash flow annually.
Payback period = 20,000 / 5,000 = 4
This means that a company can get the initial investment back in 4 years.
Payback Period Advantages and Disadvantages
The shorter the payback period, the better a company is. A long payback means that the investment dollars will be locked up for a long time, hence the project is relatively illiquid, and since the project’s cash flows must be forecast far out into the future, the project is probably quite risky.
Advantages:
Refer to the following advantages:
1. Payback period method is simple and easy to calculate and to apply fro small, repetitive investments.
2. Payback period method takes into account tax and depreciation.
Limitations:
Refer to the following limitations:
1. Payback method ignores cash flows after the pay back period.
2. Payback method ignores the time value of money and risk.
