What Is Payback Period? (With Advantages & Disadvantages)

What is Payback Period?

Payback Period is the time where a project’s net cash inflows are equal to the project’s initial cash investment. This method is often used as the initial screen process and helps to determine the length of time required to recover the initial cash outlay (investment) in the project.

Payback period is defined by CIMA as, ” The time required for the cash inflows from a capital investment project to equal the initial cash outflows.”

Usually, Organization’s must have a targeted payback period. If a payback period is larger than targeted period, the project would be rejected. But, a project is not evaluated on the basis of payback alone. 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.

The formula of Payback Period are :

Payback period = Initial Outlay / Net Cash inflows

Accept/ Rejects Criteria: The Project which has a lesser payback period will be accepted.

Advantages of Payback Method

The main advantages of payback period are as follows:

• A longer payback period indicates capital is tied up.
• Focus on early payback can enhance liquidity
• Investment risk can be assessed through payback method
• Shorter term forecasts
• This is more reliable technique
• The calculation process is quicker than and simple than any other appraisal techniques
• This is a very easily understood concept

Disadvantages of Payback Period Method

There are numbers of serious drawbacks to the payback Period Method:

• It ignores the timing of cash inflows within the payback period
• It ignores the cash flow produced after the end of the payback period and therefore the total return of the project.
• It ignores the time value of money
• It influence for excessive investment in short term projects.

Worked Example

A Machine costing $ 240,000 is to be depreciated over ten years to a nil residual value. The profits after depreciation for the first 5 years are as follows:

Year	Profits after Depreciation
1	22,000
2	27,000
3	39,000
4	49,000
5	18,000

Requirement:

Calculate Payback period to the nearest months.

Solution:

Year	Profit after depreciation	Depreciation	Cash flow ($)	Cumulative Cash Flow ($)
1	22,000	24,000	46,000	46,000
2	27,000	24,000	51,000	97,000
3	39,000	24,000	63,000	160,000
4	49,000	24,000	73,000	233,000
5	18,000	24,000	42,000	275,000

Payback Period = 4 years + (275,000 – 233,000)/73,000 * 12 months = 4.7 years.