Payback Is A Good Thing
Payback is...a bitch as the old saying goes. But there is a time and a place when payback is considered a very positive thing. That is in the world of finances.
When someone makes and investment in the hopes of getting a return on that investment, the payback of money is often used to refer to the "payback period." The payback period is defined as the period of time it takes for an investor to receive the exact amount of money back from an initial investment as we initially invested.
When To Use Payback Period
Payback period is one of several financial metrics that financial analysts can use to determine whether to invest in one capital project over another project. Payback period is a great way to compare capital projects that are very similar in required investment size and scope. By determining which one's initial investment is paid back first, the analyst can make an accurate judgement of which capital investment they should make. Payback period is also great because it is one of the simplest methods one can use to analyze capital investments.
Payback Period's Shortcomings
Although payback period is great when size and scope of the investments are similar, it may not be as useful when the size and scope of the investments are not the same. For example, a smaller investment with a faster payback period may not be as good as a larger investment with a slower payback period because the larger investment may deliver larger cash flows than the smaller investment.
Another shortcoming of the payback period method is the fact that it won't analyze cash flows after the payback period is over. What if an investment's cash flows happen to increase dramatically faster than another similar investment but it happens after the payback period is over. Since the payback period method only tells us which investment pays back faster, it won't tell us anything about cash flows projected to happen after that.
Payback Period Formula
|Payback Period =||Initial Investment|
|Cash Flow Per Period|
This is a simplied formula for when the cash flows are the same each period. If cash flows are different each period, then the formula becomes a much more manual process of doing this calculaion individually for each period's cash flow.
Putting A Twist On The Payback Period Method
So far, we've talked about the simple method of calculating payback period. A more complex payback method, is the discounted payback method. This will take greater time to calculate, but it also can put projects of different size and scope on a more level playing field. It does this by taking the projected future cash flows from an investment, and discounts each annual cash flow back to the present value. By using the present value of each year's future cash flow, it then determines a payback period with the discounted cash flows. By using discounted cash flows, the payback period will obviously be much longer, but the point is that by discounting cash flows, it creates a more apples to apples comparison between projects. But once again, this method still comes up short by not being able to account for cash flows after the payback period. Regardless, you'll want to use a payback period calculator for a calculation of this complexity.
Choosing A Discount Rate
Choosing a discount rate can be confusing. You want to choose the best discount rate when using the discounted payback period method, but choosing correctly isn't the most important thing. The most important thing is using the same discount rate when analyzing one project versus another project.
However, to choose a discount rate that makes the most sense, if you are a company, you'll want to analyze what the cost of money is for your company. This can be calculated by considering the cost to borrow money and combining that with the cost of your equity in the company. Then calculate a weighted average between the cost of debt and equity to arrive at your company's cost of money, which is the discount rate that you should use.
What Are Some Other Options?
There are other options that may better suit you and your financial analysis. Two other options are Net Present Value(NPV) and Internal Rate of Return(IRR). These two are a bit more complex, but by using an NPV IRR calculator, it can make the calculations very easy to do.
Net Present Value
The net present value is an excellent option for conducting capital project analysis. If you are using the discounted payback period method, the net present value method is very simple. All you do is discount the future cash flows back to a present value and add them together to get a total of the net present value(NPV).
Internal Rate of Return
The internal rate of return is very similar to calculating net present value. But if you are doing it by hand, the IRR calculation will take you about 10 times as long. Its strongly recommended to use an IRR calculator for this exercise. The calculation for IRR is done by determining where the discount rate works such that NPV equals zero. Using the discount rate where NPV equals zero, is that rate that equals the internal rate of return.
Payback period is one of the simplest metrics a person can use to analyze capital projects. If you are in a hurry, or don't have the luxury of a calculator, the payback period may be the method of choice. However, it isn't without its shortfalls, and for that, we recommend using NPV or IRR whenever you are close to a calculator. We hope this article was helpful. Be sure to leave a comment in the comment section.