What is the ‘Payback Period’
The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. The payback period ignores the time value of money, unlike other methods of capital budgeting, such as net present value, internal rate of return or discounted cash flow.
BREAKING DOWN ‘Payback Period’
Much of corporate finance is about capital budgeting. One of the most important concepts that every corporate financial analyst must learn is how to value different investments or operational projects. The analyst must figuring out a reliable way to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period.
Capital Budgeting and The Payback Period
Most capital budgeting formulas take the time value of money into consideration. The time value of money (TVM) is the idea that cash in hand today is worth more than it is in the future because it can be invested and make money from that investment. Therefore, if you pay an investor tomorrow, it must include an opportunity cost. The time value of money is a concept that assigns a value to this opportunity cost.
The payback period does not concern itself with the time value of money. In fact, the time value of money is completely disregarded in the payback method, which is calculated by counting the number of years it takes to recover the cash invested. If it takes five years for the investment to earn back the costs, the payback period is five years. Some analysts like the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.
Payback Period Example
Assume company A invests $1 million in a project that will save the company $250,000 every year. The payback period is calculated by dividing $1 million by $250,000, which is four. In other words, it will take four years to pay back the investment. Another project that costs $200,000 won’t save the company money, but it will make the company an incremental $100,000 every year for the next 20 years, which is $2 million. Clearly, the second project can make the company twice as much money, but how long will it take to pay the investment back? The answer is $200,000 divided by $100,000, or 2 years. Not only does the second project take less time to pay back, but it makes the company more money. Based solely on the payback method, the second project is better.