Written by The payback period is a method of capital budgeting that is used to measure the length of time required for an investment to generate cash flows sufficient to recover the initial investment cost.
It measures the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment.
The payback period represents the time it takes for the cumulative cash inflows to equal or exceed the initial cash outflow.
In simpler terms, it is the duration needed for an investment to “pay back” or recoup the initial investment amount.
We can calculate payback using two formulas depending on whether a project generates even cash inflows or uneven cash inflows.
If the project generates equal cash inflows every year, the payback period can be calculated by dividing the initial investment by the annual cash inflow
\(\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}\)
If the project generates different cash inflows every year, the payback period can be calculated by using this formula.
\(\text{Payback Period}=A +\frac{B}{C}\)
Where,
A: This is the last year with a cumulative cash flow less than the initial investment. In other words, it’s the last year before the project has paid back its initial cost. (A + 1) is the first year in which the cumulative cash inflows exceed the initial investment.
B: This is the remaining cost to be recovered at the start of year (A+1). It’s calculated by subtracting the cumulative cash flow up to year (A) from the initial investment.
C: This represents the cash flow during the first year in which the cumulative cash inflows exceed the initial investment. In other words, (C) is the cash flow in the year (A + 1).
Projects with a shorter payback period are usually preferred for investment when compared to one with longer payback period.
This is because a shorter payback period indicates a quicker recovery of the initial investment, thus reducing the risk associated with the investment.
Example 1
Company XYZ is considering an investment in a project that requires an initial cash outflow of N100,000.
The project is expected to generate annual cash inflows of N30,000 for the next five years.
Calculate the payback period for this project.
Solution:
Since the cash flow is equal, the payback period is calculated as follows:
\(\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}\)
\(\text{Payback Period} = \frac{100,0000}{30,000}=3.33\)
So it will take 3.33 years for the project to payback its initial investment.
Example 2
Calculate the payback period for a project whose initial cash outflow is N200,000, followed by cash inflows of N50,000 at the end of Year 1, N80,000 at the end of Year 2, N70,000 at the end of Year 3, and N110,000 at the end of Year 4.
Solution:
| Year | Cashflow(N) | Cumulative cash |
|---|---|---|
| 1 | 50,000 | 50,0000 |
| 2 | 80,000 | 130,000 |
| 3 | 60,000 | 190,000 |
| 4 | 110,000 | 300,000 |
The cumulative cash flow at the end of Year 3 is ₦190,000, which is less than the initial investment.
By the end of Year 4, the cumulative cash flow is ₦300,000, which is more than the initial investment.
Therefore, A=3, B=10,000, C=110,000
payback period=\(3+\frac{10,000}{110,000}=3.1\)
So, the payback period is 3.1 years
Advantages of Payback Period
1. Simple to calculate: The payback period is straightforward and easy to calculate.
It involves simple arithmetic as you only need to divide the initial investment by the annual cash inflow.
2. Useful measure of risk: The payback period provide a good measure of the risk associated with a project.
As cash flows that occur latter in a project’s life are considered more uncertain, a shorter payback period implies a quicker recovery of the initial investment and suggests a lower level of risk.
3. Focus on cash flows: Unlike other methods of capital budgeting such as the Accounting Rate of Return (ARR), the payback period uses cash flows instead of accounting profit or inflows.
Since cash flows represent the actual cash flow generated by a project, they are considered superior to accounting period.
So, payback period provides a more accurate assessment of the project’s ability to generate real monetary returns.
Disadvantages of Payback Period
1. Ignores the time value of money: One major drawback of the payback period is that it fails to consider the time value of money (TVM).
It does not account for the fact that money received in the future is worth less than money received today due to factors such as inflation and the opportunity cost of capital.
2. Does not consider cash flows beyond the payback period: The payback period only focuses on the time it takes to recoup the initial investment.
It does not consider cash flows that occur after the payback period.
3. May lead to excessive investment in short-term projects: Since the payback period focuses on how quickly the initial investment can be recovered, it may lead businesses to invest excessively in short-term projects at the expense of potentially more profitable long-term projects.
4. Unable to distinguish between projects with the same payback period: If two or more projects have the same payback period, this method doesn’t provide any way to distinguish between them.
