Advantages of the payback period
/What is the Payback Period?
The payback period measures the time it takes for an investment to recover its initial cost through generated cash flows. It is calculated by dividing the initial investment by the annual cash inflows, providing a simple way to assess how quickly a project will break even. For example, if a $100,000 investment is needed and there is an expectation of the project generating positive cash flows of $25,000 per year thereafter, the payback period is considered to be four years.
A shorter payback period is generally preferred, as it indicates a faster return on investment and lower risk exposure. However, this method does not consider cash flows beyond the payback period or the time value of money, making it less useful for evaluating long-term profitability.
What are the Advantages of the Payback Period?
There are several advantages to the payback period approach, which are noted below:
Useful for small investments. The payback period is especially useful for a business that tends to make relatively small investments, and so does not need to engage in more complex calculations that take other factors into account, such as discount rates and the impact on throughput.
Calculation simplicity. The payback concept is extremely simple to understand and calculate. When engaged in a rough analysis of a proposed project, the payback period can probably be calculated without even using a calculator or electronic spreadsheet.
Risk focus. The analysis is focused on how quickly money can be returned from an investment, which is essentially a measure of risk. Thus, the payback period can be used to compare the relative risk of projects with varying payback periods.
Liquidity focus. The payback period analysis favors projects that return money quickly, so using it tends to result in investments with a higher degree of short-term liquidity. This is a useful concept during times when long-term returns on investment are uncertain. This situation can arise not only when the economic situation is unsettled, but also when a business is entering a new market, and so has little information about its prospects there.
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Summary of Payback Period Analysis
Consequently, despite its lack of rigorous analysis, there are situations in which the payback period can be used to evaluate prospective investments. We suggest that it be used in conjunction with other analysis methods to arrive at a more comprehensive picture of the impact of an investment on a business.
Example of the Payback Method
The calculation of the payback period is:
$100,000 Investment ÷ $25,000 Annual cash flows = 4 Years payback