payback method

(noun)

A simple calculation that allows an assessment of the cost of a project via the time it will take to be repaid.

Related Terms

Examples of payback method in the following topics:

  • Defining the Payback Method

    • The payback method is a method of evaluating a project by measuring the time it will take to recover the initial investment.
    • As a stand-alone tool to compare an investment, the payback method has no explicit criteria for decision-making except, perhaps, that the payback period should be less than infinity.
    • An implicit assumption in the use of the payback method is that returns to the investment continue after the payback period.
    • The payback method does not specify any required comparison to other investments or even to not making an investment .
    • The payback method is a simple way to evaluate the number of years or months it takes to return the initial investment.

  • Disadvantages of the Payback Method

    • The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
    • An implicit assumption in the use of payback period is that returns to the investment continue after the payback period.
    • Payback ignores the time value of money.
    • Payback also ignores the cash flows beyond the payback period, thereby ignoring the profitability of the project.
    • Thus, one project may be more valuable than another based on future cash flows, but the payback method does not capture this.

  • Advantages of the Payback Method

    • All else being equal, shorter payback periods are preferable to longer payback periods.
    • The payback period is an effective measure of investment risk.
    • The project with a shortest payback period has less risk than with the project with longer payback period.
    • Payback period method is suitable for projects of small investments.
    • The payback method is a simple way to evaluate the number of years or months it takes to return the initial investment.

  • Discounted Payback

    • The payback method is more effective at accurately projecting payback periods when it is discounted to incorporate the time value of money.
    • The payback method is quite a simple concept.
    • If a payback method does not take into account the time value of money, the real net present value (NPV) of a given project is not being calculated.
    • So a simple example of a payback period without time value of money (without discounted payback) would be as follows:
    • Apply the concept of time value of money to the payback method

  • Calculating the Payback Period

    • To calculate a more exact payback period: Payback Period = Amount to be initially invested / Estimated Annual Net Cash Inflow.
    • Payback period is usually expressed in years.
    • Payback period method does not take into account the time value of money.
    • Some businesses modified this method by adding the time value of money to get the discounted payback period.
    • The modified payback period algorithm may be applied then.

  • Advantages of the IRR Method

    • The IRR method is easily understood, it recognizes the time value of money, and compared to the NPV method is an indicator of efficiency.
    • One advantage of the IRR method is that it is very clear and easy to understand.
    • The IRR method also uses cash flows and recognizes the time value of money.
    • Compared to payback period method, IRR takes into account the time value of money.
    • This is because the IRR method expects high interest rate from investments.

  • Defining Capital Budgeting

    • Payback period: For example, a $1000 investment which returned $500 per year would have a two year payback period.
    • Many formal methods are used in capital budgeting, including the techniques as followed:
    • 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.
    • The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
    • Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

  • Ranking Investment Proposals

    • Several methods are commonly used to rank investment proposals, including NPV, IRR, PI, payback period, and ARR.
    • To choose the most valuable investment option, several methods are commonly used:
    • NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects.
    • 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 widely used because of its ease of use despite the recognized limitations: The time value of money is not taken into account.

  • Loans and Loan Amortization

    •  When lending money (or borrowing, depending on your perspective), it is common to have multiple payback periods over time (i.e. multiple, smaller cash flow installments to pay back the larger borrowed sum).

  • Defining the Cost of Capital

    • These options tend to have lower interest rates, and long payback periods.