The Payback Period: Meaning, Example, Advantages and Disadvantages

A massive loss on an investment is the single biggest threat to small and medium businesses. Budgets are always tight in your industry, and big losses can have a major impact, unless you are at the top. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. One way corporate financial analysts do this is with the payback period. Not every business is going to want to invest in the short-term to get their money back as quickly as they can. Investment is also a long-term game, and the payback period method is going to show managers how a particular project will likely pay off over time.

  • The whole evaluation will also be weighed in favor of capitalizing on short-term gains.
  • The Hasty Rabbit Corporation is considering a $150,000 expansion to the production line that makes their top-selling sneaker – the Blazing Hare.
  • Payback period means the period of time that a project requires to recover the money invested in it.
  • When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period.

Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost. The payback method is still commonly utilized by organizations despite its disadvantages. The technique performs well when assessing moderate-sized projects and those with generally steady cash flows. Additionally, small enterprises, for whom liquidity is more essential than profits, frequently use it. Business managers, investors, financial experts, and businesses frequently find themselves in situations where they must choose between projects. Due to the scarcity of resources, such business decisions are extremely important.

Advantages of payback period

With this type of budget, a project’s short-term cash flow is put under a lot of pressure. The whole evaluation will also be weighed in favor of capitalizing on short-term gains. In some cases, it may be smarter to consider cash flow over a longer period.

The Hasty Rabbit Corporation is considering a $150,000 expansion to the production line that makes their top-selling sneaker – the Blazing Hare. The company receives a gross profit of $40 for each pair of sneakers, and the expansion will increase output by 1,250 pairs per year. The sales manager has assured upper management that Blazing Hare sneakers are in high demand, and he will be able to sell all of the increased production. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

Net Present Value Method Vs. Payback Period Method

For both of these projects, Sam’s estimates that it will take five years for cash inflows to add up to $16,000. The payback period method does not differentiate between these two projects. The simplicity of the payback period method is one of its greatest advantages.

Alternatives to payback period

This is considered the first screening method, but organizations may use any other techniques to appraise the project. The organization considers the net cash inflows to appraise to appraise the project, Net Cash inflows means Profit after tax plus Depreciation. We can calculate payback using two formulas depending on whether a project generates even cash inflows or uneven cash inflows. Suppose a company gets a shorter payback period, which is the goal of the payback period. Cash flows may stop once the payback period ends, making such a project meaningless.

Management Notes

The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. Projects with a shorter payback period are usually preferred for investment when compared to one with longer payback period. In reality, projects are unlikely to have constant annual projected returns. In this case, setting up a table in Excel will help evaluate and estimate the payback period. According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.

Disadvantages of Payback Period

Without solid numbers to back it up, choosing between similar projects can be challenging. ROI can help you determine which investment is going to be better based on payback period, which should make decision-making easier. The manager will need all the information and help he/she can get in order to make a decision when there is little else to distinguish multiple projects. Payback period method is a method used by businesses to determine how much cash flow will come in from different projects, and which one will have the quickest return on investment. As the equation above shows, the payback period calculation is a simple one.

The Advantages and Disadvantages of the Internal Rate of Return Method

The payback technique is highly helpful in sectors with a high degree of uncertainty or that experience quick technological change. This uncertainty makes it challenging to forecast the coming year’s yearly cash inflows. Utilizing and working on projects with short payback periods helps lower the risk of a loss due to obsolescence.

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