Recovering the Costs of Investments

Payback Period

Summary/Abstract

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

PP =   ----------------------------------------

                    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 model:

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

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