Payback Period

What is the payback period? Payback is perhaps the simplest method of investment appraisal.

The payback period is the time it takes for a project to repay its initial investment.

Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months).

Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows.

Looking at the example investment project in the diagram above, the key columns to examine are the annual "cash flow" and "cumulative cash flow" columns.

Initially the project involves a cash outflow, arising from the original investment of £500,000 and some project losses in Year 1 of £50,000. Thereafter the project generates positive annual cash flows.

By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000.

To calculate the precise payback period, a simple calculation is required to work out how long it took during Year 4 for the payback point to occur. The trick is to make an assumption that the cash flows arise evenly during each period. That allows the following calculation:

• Payback for the project arises £200,000/£450,000 through Year 4
• = approx 23 weeks through Year 4
• So the payback period = 3 years + 23 weeks

The main advantages and disadvantages of using Payback as a method of investment appraisal are as follows:

Advantages of Payback

Simple and easy to calculate + easy to understand the results

Focuses on cash flows – good for use by businesses where cash is a scarce resource

Emphasises speed of return; may be appropriate for businesses subject to significant market change

Straightforward to compare competing projects

Disadvantages of Payback

Ignores cash flows which arise after the payback has been reached – i.e. does not look at the overall project return

Takes no account of the "time value of money"

May encourage short-term thinking

Ignores qualitative aspects of a decision

Does not actually create a decision for the investment