Payback Period in Capital Budgeting
A Historical Capital Budgeting Decision Method
In capital budgeting for a business firm, historically, the payback period is the selection criteria that most business firm use to select capital projects. Even today, small businesses find the payback period selection criteria most useful. Small business owners like to look at the time it takes them to earn back their initial investment in a capital project.
What is a Capital Project?
A capital project is usually defined as buying or investing in a fixed asset which, by definition, will last more than one year.
Current projects last less than one year.
Payback Period Capital Budgeting Decision Method
The definition of payback period for capital budgeting purposes is simple. The payback period is the number of years it takes to payback the initial investment of a capital project from the cash flows that the project produces.
The capital project could be buying a new plant or building or buying a new or replacement piece of equipment. In this example, it is buying real estate. Most firms set a cut-off payback period, maybe 3 years depending on their business. In other words, in this example, if the payback is 2.5 years, the firm would purchase the asset or invest in the project. If the payback were 4 years, it would not.
Calculating Payback Period
Most small businesses prefer a simple calculation, or approximation, for payback period:
Payback Period = Investment Required/Net Annual Cash Inflow*
*The net annual cash inflow is what the investment generates in cash each year. However, if this investment was a replacement investment; for example, a machine replaced an obsolete machine, then the net annual cash inflow becomes the incremental net annual cash flow from the investment.
Payback occurs the year (plus a number of months) before the cash flow turns positive.
Larger firms may prefer a more complex calculation for payback so that they may gather more information. Here is an alternative payback period calculation:
Payback Period = Number of years prior to full recovery of investment + Unrecovered cost at start of year/Cash flow during full recovery year
This slightly more extensive equation may give you a little more information. For purposes of examples in this article, we will stick with the simpler payback period equation.
Example of Payback Period Calculation
EXAMPLE: Machine A costs $20,000 and the firm expects payback at the rate of $5,000 per year. Machine B costs $12,000 and the firm expects payback at the same rate as Machine A.
Machine A = $20,000/$5,000 = 4 years
Machine B = $12,000/$5,000 = 2.4 years
With all other things equal, the firm would choose Machine B.
Is Payback Period a Good Capital Evaluation Decision Method
Payback period has many deficiencies. If you add information to the analysis, you will see some of its deficiencies. For example, if you add the economic lives of the two machines, you could get a very different answer. So, one deficiency of payback is that is cannot determine the useful lives of the equipment or plant it is evaluating.
Perhaps an even more important criticism of payback period is that it does not consider time value of money. Cash inflows from the project that are scheduled to be received 2-10 years, or longer, in the future are weighted exactly the same as the cash flow expected to be received in year one.
Due to risk, that is not good financial practice.
Last, but not least, payback period does not handle a project with uneven cash flows well. If a project has uneven cash flows, then payback period is a fairly useless capital budgeting method.
The one advantage of payback period is that it is a "quick and dirty" method of capital budgeting that can give management some sort of rough estimate concerning when the project will pay back their initial investment. Even considering the more advanced methods available, it seems that management still wants to rely on this tried and true method.