Payback Period Method

Payback period shows the length of time required to repay the total initial investment through investment cash flows. A project is acceptable if its payback period is shorter than or equal to the cutoff period.

Payback Period Formula

Payback period = Initial investment ÷ Cash flow per year

Calculation

For example, a company invested $20,000 for a project and expected $5,000 cash flow annually.
Payback period = 20,000 / 5,000 = 4
This means that a company can get the initial investment back in 4 years.

Payback Period Advantages and Disadvantages

The shorter the payback period, the better a company is. A long payback means that the investment dollars will be locked up for a long time, hence the project is relatively illiquid, and since the project’s cash flows must be forecast far out into the future, the project is probably quite risky.

Advantages:

Refer to the following advantages:
1. Payback period method is simple and easy to calculate and to apply fro small, repetitive investments.
2. Payback period method takes into account tax and depreciation.

Limitations:

Refer to the following limitations:
1. Payback method ignores cash flows after the pay back period.
2. Payback method ignores the time value of money and risk.

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