What Is The Payback Period And How To Use It

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 invests with the hopes of getting a return on that investment, the payback of money often gets used to refer to the "payback period."  The payback period is defined as the 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

The 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.  The payback period is a great way to compare capital projects that are very similar in the required investment size and scope.  By determining which initial investment gets paid back first, the analyst can make an accurate judgment of which capital investment they should make.  The payback period is also excellent because it is one of the simplest methods to analyze capital investments. 

Payback Period's Shortcomings  

Although the payback period is excellent when the 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 more substantial investment with a slower payback period because the more substantial investment may deliver more significant 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 occurs 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

This formula is a simplified formula for when the cash flows are the same each period.  If cash flows are different each period, then the equation becomes a much more manual process by doing this calculation 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 the payback period.  A more complex payback method is the discounted payback method.  This method 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 be more extended, 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 your company's cost of money is.  This gets figured by considering the cost to borrow money as well as the cost of equity.  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 complicated, but by using an NPV IRR calculator, it can make the calculations easier. 

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 straightforward.  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 ten times as long.  Its strongly recommended using an IRR calculator for this exercise.  The calculation for IRR gets 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.  

Conclusion

The payback period is one of the most straightforward 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.