The Payback Period (PP) is perhaps the
simplest method of looking at one or more investment projects or ideas.
The Payback Period method focuses on recovering the cost of investments.
PP represents the amount of time that it takes for a capital budgeting
project to recover its initial cost.
The Payback Period Calculation
is as follows:
The Costs of Project / Investment
Annual Cash Inflows
The PP concept holds that all other things being equal, the better investment
is the one with the shorter payback.
Example of a Payback Period calculation:
For example, take a project costing a total of $200,000. The expected
returns of the project amount to $40,000 annually. PP would be $200,000
÷ $40,000 = 5 years.
PP certainly has the virtue of being easy to compute and easy to
understand. But that very simplicity carries weaknesses with it. There
are al least two major problems associated with the Payback Period
1) PP ignores any benefits that occur after the Payback Period, and so
does not measure total incomes
2) PP ignores the time value of money
Because of these two reasons, more professional methods of capital
budgeting are advisable:
Compare with Payback Period:
Net Present Value |
Internal Rate of Return |
Discounted Cash Flow
More management models