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    Payback Period

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    Mikhael Tinambunan
    The document discusses the payback period method for evaluating investment projects. It explains that payback period measures how long it will take to earn back the initial money invested in a project. The simpler payback period calculation ignores the time value of money, which can lead to unrealistic expectations. When time value of money is considered using present value calculations, project payback periods are often significantly different. While a simple measure, payback period is still an important initial consideration for evaluating and comparing multiple investment projects.

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    Payback Period

    Uploaded by

    Mikhael Tinambunan
    56 views2 pages
    The document discusses the payback period method for evaluating investment projects. It explains that payback period measures how long it will take to earn back the initial money invested in a project. The simpler payback period calculation ignores the time value of money, which can lead to unrealistic expectations. When time value of money is considered using present value calculations, project payback periods are often significantly different. While a simple measure, payback period is still an important initial consideration for evaluating and comparing multiple investment projects.

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    The document discusses the payback period method for evaluating investment projects. It explains that payback period measures how long it will take to earn back the initial money invested in a project. The simpler payback period calculation ignores the time value of money, which can lead to unrealistic expectations. When time value of money is considered using present value calculations, project payback periods are often significantly different. While a simple measure, payback period is still an important initial consideration for evaluating and comparing multiple investment projects.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    56 views2 pages

    Payback Period

    Uploaded by

    Mikhael Tinambunan
    The document discusses the payback period method for evaluating investment projects. It explains that payback period measures how long it will take to earn back the initial money invested in a project. The simpler payback period calculation ignores the time value of money, which can lead to unrealistic expectations. When time value of money is considered using present value calculations, project payback periods are often significantly different. While a simple measure, payback period is still an important initial consideration for evaluating and comparing multiple investment projects.

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    Download as PDF, TXT or read online from Scribd
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    Payback Period

    At first glance, payback is a simple investment appraisal technique, but it can quickly become complex.

    What It Measures
    How long it will take to earn back the money invested in a project.

    Why It Is Important
    The straight payback period method is the simplest way of determining the investment potential of a major
    project. Expressed in time, it tells a management how many months or years it will take to recover the
    original cash cost of the project—always a vital consideration, and especially so for managements evaluating
    several projects at once.
    This evaluation becomes even more important if it includes an examination of what the present value of
    future revenues will be.

    How It Works in Practice


    The straight payback period formula is:
    Payback period = Cost of project ÷ Annual cash revenues
    Thus, if a project costs $100,000 and is expected to generate $28,000 annually, the payback period would
    be:
    100,000 ÷ 28,000 = 3.57 years
    If the revenues generated by the project are expected to vary from year to year, add the revenues expected
    for each succeeding year until you arrive at the total cost of the project.
    For example, say the revenues expected to be generated by the $100,000 project are:

    Year Revenue Total


    Year 1 $19,000 $19,000
    Year 2 $25,000 $44,000
    Year 3 $30,000 $74,000
    Year 4 $30,000 $104,000
    Year 5 $30,000 $134,000

    Thus, the project would be fully paid for in Year 4, since it is in that year that the total revenue reaches the
    initial cost of $100,000.
    The picture becomes complex when the time value of money principle is introduced into the calculations.
    Some experts insist this is essential to determine the most accurate payback period. Accordingly, present
    value tables or computers (now the norm) must be used, and the annual revenues have to be discounted by
    the applicable interest rate, 10% in this example. Doing so produces significantly different results:

    Year Revenue Present value Total


    Year 1 $19,000 $17,271 $17,271
    Year 2 $25,000 $20,650 $37,921
    Year 3 $30,000 $22,530 $60,451
    Year 4 $30,000 $20,490 $80,941
    Year 5 $30,000 $18,630 $99,571

    Payback Period 1 of 2
    www.qfinance.com
    This method shows that payback would not occur even after five years.

    Tricks of the Trade


    • Clearly, a main defect of the straight payback period method is that it ignores the time value of money
    principle, which, in turn, can produce unrealistic expectations.
    • A second drawback is that it ignores any benefits generated after the payback period, and thus a
    project that would return $1 million after, say, six years might be ranked lower than a project with a
    three-year payback that returns only $100,000 thereafter.
    • Another alternative to calculating by payback period is to develop an internal rate of return.
    • Under most analyses, projects with shorter payback periods rank higher than those with longer
    paybacks, even if the latter promise higher returns. Longer paybacks can be affected by such factors
    as market changes, changes in interest rates, and economic shifts. Shorter cash paybacks also enable
    companies to recoup an investment sooner and put it to work elsewhere.
    • Generally, a payback period of three years or less is desirable; if a project’s payback period is less than
    a year, some contend it should be judged essential.

    To see this article on-line, please visit


    http://www.qfinance.com/business-strategy-calculations/payback-period

    Payback Period 2 of 2
    www.qfinance.com

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