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What is Payback Period in Capital Budgeting?
Payback is a method related to capital budgeting. The payback period in capital budgeting refers to the time required for the return on an investment (ROI) to "repay" or pay back the total sum of the original investment.
Payback is a popular method of evaluation of investment because it is easy to understand and calculate regardless of what it actually means.
Despite being a non-DCF evaluation method, payback is used extensively in the evaluation of investments for its simplicity in calculation and application. It is quite useful in comparing the calculation of similar investments.
The payback method doesn’t have any specific criteria for the evaluation of investments as a standalone tool. The only necessity in using the payback period method is that it should be less than infinity.
Limitations of the Payback Method
Despite being a simple way of evaluation of investments, the payback method has some serious limitations because it doesn’t consider the time value of money, risks, and financing issues.
Although the time value of money can be measured by including the weighted average cost of the capital discount, the payback tool should not be used in isolation.
Economists and financial managers alternately use net present value (NPV) and internal rate of return (IRR) along with the payback method to limit the shortcomings of the payback method in general.
An explicit assumption in using the payback method is that ROI continues even after the payback period.
Calculation of Payback Period
The payback period is a part of capital budgeting wherein the period of time required for the return on investment to pay back the sum of the original investment is calculated.
The payback period is generally expressed in years. The process starts by calculating Net Cash Flow for each year where,
Year 1 Net Cash Flow = Year 1 Cash Inflow – Year 1 Cash Outflow
Then, Cumulative Cash Flow is calculated where,
Cumulative Cash Flow = Year 1 Net Cash flow + Year 2 Net Cash Flow + Year 3 Net Cash Flow…
This accumulation is carried on by year until Cumulative Cash Flow becomes a positive number. The year in which the cumulative cash inflow becomes positive that year is the payback year.
more exact payback period is calculated using the formula −
$$\mathrm{Payback\:Period =\frac{Amount\:to \:be \:Initially\: Invested}{Estimated \:Annual \:Net \:Cash Inflow}}$$
The payback method does not consider the time value of money. Some economists modify this method by including the time value of money to find a discounted payback period. The cash inflows of the project are discounted by a given discount rate (cost of capital), and then the usual steps are followed for calculating the payback period.
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