Payback period

Payback periodincapital budgetingrefers to the time required torecoupthefundsexpended in aninvestment,or to reach thebreak-even point.^[1]

For example, a $1000 investment made at the start of year 1 whichreturned$500 at the end of year 1 and year 2 respectively would have a two-year payback period. Payback period is usually expressed inyears.Starting from investment year by calculatingNet Cash Flowfor each year:

${\text{Net Cash Flow Year 1}}={\text{Cash Inflow Year 1}}-{\text{Cash Outflow Year 1}}$

Then:

${\text{Cumulative Cash Flow}}=({\text{Net Cash Flow Year 1}}+{\text{Net Cash Flow Year 2}}+\ldots +{\text{Net Cash Flow Year n}})$

Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

Description

Payback does not allow for thetime value of money.Payback period intuitively measures how long something takes to "pay for itself."All else being equal,shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below. SeeCut off period.

The term is also widely used in other types of investment areas, often with respect toenergy efficiencytechnologies, maintenance, upgrades, or other changes. For example, acompact fluorescentlight bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reducedoperating costs.

Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such asenergy payback period^[2]^[3](the period of time over which theenergy savingsof a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.

Purpose

Payback period is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria fordecision-making(except, perhaps, that the payback period should be less than infinity).

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for thetime value of money,risk,financing,or other important considerations, such as theopportunity cost.Whilst the time value of money can be rectified by applying aweighted averagecost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.

Alternative measures of "return" preferred by economists arenet present valueandinternal rate of return.An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

Construction

Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.^[4]

It can also be calculated using the formula:

Payback Period = (p - n)÷p + n_y
= 1 + n_y- n÷p (unit:years)

Where
n_y= The number of years after the initial investment at which the last negative value of cumulative cash flow occurs.
n= The value of cumulative cash flow at which the last negative value of cumulative cash flow occurs.
p= The value of cash flow at which the first positive value of cumulative cash flow occurs.

Thisformulacan only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. If the cumulativecash flowdrops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can't be applied. This formula ignores values that arise after the payback period has been reached.

Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The modified payback periodalgorithmmay be applied then.

The sum of all of the cash outflows is calculated.
The cumulative positive cash flows are determined for each period.
The modified payback is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.

Shortcomings

Payback period doesn't take into consideration the time value of money and therefore may not present the true picture when it comes to evaluating cash flows of a project. This issue is addressed by usingDPP,which uses discounted cash flows.

Payback also ignores the cash flows beyond the payback period. Most majorcapital expenditureshave a long life span and continue to provide cash flows even after the payback period. Since the payback period focuses on short term profitability, a valuable project may be overlooked if the payback period is the only consideration.

References

^Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010).Marketing Metrics: The Definitive Guide to Measuring Marketing Performance.Upper Saddle River, New Jersey: Pearson Education, Inc.ISBN 0-13-705829-2.TheMarketing Accountability Standards Board (MASB)endorses the definitions, purposes, and constructs of classes of measures that appear inMarketing Metricsas part of its ongoingCommon Language: Marketing Activities and Metrics Project.
^ Marco Raugei; Pere Fullana-i-Palmer; Vasilis Fthenakis (March 2012)."The Energy Return on Energy Investment (EROI) of Photovoltaics: Methodology and Comparisons with Fossil Fuel Life Cycles"(PDF).bnl.gov.Archived(PDF)from the original on 8 March 2016.
^Ibon Galarraga, M. González-Eguino, Anil Markandya (1 January 2011).Handbook of Sustainable Energy.Edward Elgar Publishing. p. 37.ISBN 978-0857936387.Retrieved9 May2017– via Google Books.{{cite book}}:CS1 maint: multiple names: authors list (link)
^Williams, J. R., et al.,Financial and Managerial Accounting,McGraw-Hill, 2012, p. 1117.

External links

https://www.calculator.net/payback-period-calculator.html

[Marketing_Metrics-1] Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010).Marketing Metrics: The Definitive Guide to Measuring Marketing Performance.Upper Saddle River, New Jersey: Pearson Education, Inc.ISBN 0-13-705829-2.TheMarketing Accountability Standards Board (MASB)endorses the definitions, purposes, and constructs of classes of measures that appear inMarketing Metricsas part of its ongoingCommon Language: Marketing Activities and Metrics Project.

[2] Marco Raugei; Pere Fullana-i-Palmer; Vasilis Fthenakis (March 2012)."The Energy Return on Energy Investment (EROI) of Photovoltaics: Methodology and Comparisons with Fossil Fuel Life Cycles"(PDF).bnl.gov.Archived(PDF)from the original on 8 March 2016.

[Galarraga-3] Ibon Galarraga, M. González-Eguino, Anil Markandya (1 January 2011).Handbook of Sustainable Energy.Edward Elgar Publishing. p. 37.ISBN 978-0857936387.Retrieved9 May2017– via Google Books.{{cite book}}:CS1 maint: multiple names: authors list (link)

[4] Williams, J. R., et al.,Financial and Managerial Accounting,McGraw-Hill, 2012, p. 1117.

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