Period of time required to get back the cost of investment
The payback period is an accounting metric in capital budgeting that refers to the amount of time it takes to recover the funds invested in a project or reach a break-even point.
The break-even point, a highly usedand business, simply means that there are no losses or gains, or in other words, that total costs equal total revenue for a specific venture.
Unlike the break-even point, which uses the number of units sold to offset the costs, the payback is the length of time required for an investment to pay back for itself.
The out put of using the payback tool is expressed in years or a fraction of years. It is a function of theand the average annual net cash flows generated by the investment.
It's important to knowis in order to have a better understanding. The term cash flow signifies the amount of money that an investment generates or consumes over a period of time.
Many industry professionals use this capital budgeting tool, such as fund managers and financial analysts, to calculate the time required for a, which can be:
- Property, Plant, and equipment (PP&Е)
- Among other investments
Payback period is a vital metric for evaluating the time taken for an investment to.
It should be used in conjunction with and complemented by other capital budgeting techniques, such as internal rate of return () and ( ), in order to have a more thorough understanding before making an investment decision.
- The payback period is the time it takes for an investment to recover its initial funds or reach a break-even point.
- It is a simple and practical accounting metric that is suitable for businesses of various sizes and industries.
- It provides liquidity and risk management benefits, as a shorter payback period indicates lower risk and quicker access to cash.
- Payback period has limitations, such as disregarding the time value of money, ignoring project profitability beyond the payback period, and neglecting the project's rate of return.
- The payback period should be used in conjunction with other capital budgeting techniques like NPV, IRR, MIRR, and profitability index to make more informed investment decisions.
The payback period is a valuable and simple analysis tool that can facilitate the comparison of alternative investments. The following hypothetical example will provide better clarification regarding comparing investments.
Let's assume that project A requires an initial capital investment of $500,000 and that every year there is an incremental $50,000 sales benefit. Now, let's look at project B, which demands $1,000,000 of upfront spending with an annual return of $200,000.
Capital investments are critical to the core operations of companies. The capital investments contribute to the:
- Expansion and scaling of operations
All of which are pivotal for a company's long-term success. In the first case, the period over which the capital is paid back for project A is 10 years, while for project B it is 5 years.
This is calculated by dividing the initial investment by its annual return, as shown in the formula below.
Based on this example, project B presents a better investment opportunity. Conversely, a good investment is one that takes less time to generate returns or is of a relatively short length.
Payback period = Initial investment / Annual cash flow
The calculation can also be performed using a payback period calculator or in Excel for the provided reference values.
Despite its simplicity, the payback period is a practical and handy accounting metric that offers a number of advantages worth considering.
1. Suitability for businesses of various sizes and different industries
It is used by small or medium companies that make relatively small investments with constant annual cash flows.
Government projects, risky capital-intensive projects, cash-strapped businesses that need cash availability sooner rather than later, and companies in the industrial, basic materials, energy, and manufacturing sectors can make use of the measure.
It provides a straightforward and easy way for calculating even and uneven cash flows. The simplest way to differentiate between even and uneven cash flows is by evoking the concept of an annuity.
Even cash flows produce the same amount of cash annually over a period of time, for example, $25,000 annually for 5 years. On the other hand, uneven cash flows generate various annual cash streams over a period of time.
For example, $50,000 in the first year, $30,000 in the second year, $80,000 in the third year, etc.
Another of its benefit is that it serves as a liquidity provider in the short term. This means that companies measure their access to cash
It also has the function of helping with managing investment risk—the shorter the time it takes to recover the initial investment, the less risky the investment.
By risk, we mean the uncertainty around circumstances that can exert beneficial or adverse effects on a firm's operations.
Evaluating the risk is especially important when the liquidity factor is a significant consideration. In conditions of uncertainty, the shorter payback means good cushioning and risk mitigation.
Despite its positive aspects, this accounting metric has its downsides. Listed below are a few of the major downsides:
1. Disregards time value of money (TVM)
A crucial concept in finance, the time value of money states that a sum of money received now is worth more than the same amount received later in the future due to changes in its earning potential. The TVM is frequently associated with the net present value (NPV) of money.
It’s important to remember that the present value of cash flows is worth more than their future value. This is due to the fact that the future value is affected by factors such as inflation, eroding purchasing power, liquidity, and default risks.
The TVM provides more sophisticated and detailed investment information than the simple time frame of the return on investment which is disregarded by this tool.
As a result, it does not provide adjustments for what a cash flow will be worth now and in the future, nor does it make any provisions for collecting the money. That is, a cash flow of $300 today is worth more than the same amount in 5 years time.
2. Ignores project profitability
It measures the time it takes to regain the invested capital and reach the break-even point. If a venture has a 10-year period of payback, the measure does not consider the cash flows after the 10-year time frame.
Depending on the nature of the investment and the time horizon, it may take a while for the project to return the invested capital, if at all.
If cash flows after the break-even point decrease significantly, the project's viability is in jeopardy and can lead to losses.
Conversely, if proceeds after the period have a dramatic uptick and move into the green, then the investment is a wise decision. It doesn't represent these two scenarios - profitability or lack thereof. Consequently, this is another serious limitation of the payback model.
3. Neglects project rate of return
the rate of return (RoR) is a cash flow measure. It is expressed as a percentage and is a function of the initial investment capital and the final value, which includes dividends and interest.
The rate of return can be positive or negative, thus, resulting in a gain or a loss for a specific investment. It correlates with whether an investment is profitable or not. Ultimately, the aim of project investment is to achieve profitability beyond that in which it turns breakeven.
The formula for calculating RoR is given below:
R = (Vf - Vi) / Vi
- R is the rate of return
- Vf is the final value inclusive of interest and dividends
- Vi is the initial investment
With this in mind, it becomes clear that the tool is insufficient for estimating the value of an investment and its returns.
It should be used with, but not limited to, the mentioned cash flow metrics, NPV and RoR, to build a more exhaustive picture of the viability of a project, its downside risks, and trade-offs.
The basic payback period, as presented above, and its benefits and limitations give an overall idea of the concept.
The capital budgeting measure has two variants outlined below with their respective advances and disadvantages.
1. Modified Payback Period
Just like the basic payback period, its modified counterpart calculates the time required to retrieve the invested funds.
However, it adds a layer of complexity to the basic model by introducing the total sum of all cash outflows and recording all positive cash inflows. The positive cash flows are calculated for each time period i.e. year.
The modified payback model is presented as the year when the cumulative positive cash flows are greater than the total cash flows.
2. Discounted Payback Period (DPP)
As the name suggests, it recognizes the TMV and discounts future cash flows to their present value for every period.
The discounted cash flows are then compared to the initial cost - the point when the discounted cash flows equal the investment outflow is when the investment or project breaks even.
The point after breaking even is when the total of discounted cash inflows will exceed the initial cost. The DPP is, therefore, a measure of profitability.
In order to establish DPP, we need to know:
- The initial investment cost
- The expected timeframe of the discounted payback
- Generally, a suitable discounted payback method occurs before the target timeframe. Let’s assume the target timeframe is 8 years and the DPP occurs in the 6th year, then the investment is worth taking on. Again, the shorter the period, the better. Longer periods increase the risk and as such, aren’t that worthwhile.
- The discount rate - also known as the required rate of return (RRR) or hurdle rate. The discount rate is the appropriate and somewhat subjective rate of return required by an investor or firm to compensate for the risk they’re taking on by investing in a venture or holding a company’s stock.
- The estimated cash flows
The DPP can be calculated in Excel or by using a discounted payback calculator. All of the above data must be plugged into the model in order to perform the calculation.
The main advantage of the DPP is that it gives more accurate information about the timeframe of the investment recovery by using the present value of estimated future cash flows, which is achieved by using the appropriate discount rate and factoring in the important TVM.
In the arsenal of corporate finance tools for capital budgeting, it’s worth seeing how it compares to other capital budgeting methods such as NPV, IRR, modified IRR, and profitability index.
Understanding the nuances, advantages, and limitations of each metric is essential to make informed capital budgeting decisions.
Let's contrast the Payback Period against other capital budgeting metrics, providing a robust comparison to guide business leaders, financial managers, and investors towards more strategic investment decisions.
The net present value, or NPV, discounts future cash flows to their present value using an appropriate discount rate and the number of time periods during which cash flows will be generated.
The present value of the discounted future cash flows is compared to the initial capital outlay. If the result returns a positive number over the time period, then the investment is worth pursuing.
Alternatively, if the present value of the discounted cash flows is lower than the initial capital, the result is negative, and the investment shouldn’t be considered.
The NPV measure has two downsides:
- The calculation of the discount rate - as certain subjective assumptions are made in calculating it. If it is too high, an investment may be discarded as the resulting valuation would be lower. If it’s too low, it creates a biased decision that could ignore other profitable and/or better opportunities.
- The NPV is not particularly practical for projects of different sizes - as the output of the NPV is expressed in a currency value rather than a percentage, the number will be influenced by the input. This means that a project may have a better NPV because of its smaller size.
A regularly used metric by managers to evaluate the viability of investments, the internal rate of return, or IRR, is the rate of return that makes a project worthwhile investing in. It can also be referred to as an economical rate of return.
If the IRR of an investment is higher than the company’s or the investor’s required rate of return, this sends a strong signal that it is worth undertaking.
Conversely, if the IRR falls below the required rate of return that the company or the investor seeks, then other more economically viable alternatives should be considered.
The IRR produces a single rate of return, expressed as a percentage. This could prove problematic when dealing with multiple cash flows at different discount rates, for which the NPV would be more beneficial.
It also assumes that the cash flow generated during the investment period is reinvested at the same rate, which is almost never the case. Hence, the best use case of IRR is when the investment being analyzed does not generate a lot of intermediate cash flows.
In some cases, the same project might have two internal rates of return, which can lead to ambiguity and confusion. Multiple internal rates of return occur when dealing with non-normal cash flows, also called unconventional or irregular cash flows.
Unconventional cash flows refer to the streams of revenues and/or expenses that a business generates and/or incurs that are unexpected and haven't been adjusted for in the predictions.
In addition, the IRR assumes that the generated cash flows are reinvested at the generated rate. This can cause inaccuracies if the received cash flows can’t be reinvested at, let’s say, at 6% when the IRR is 14%.
The modified IRR, or MIRR, is a more complex measure of profitability. Due to its complexity, it’s used less often than the IRR. However, the major benefit of MIRR is that it provides a more realistic idea of the return on investment.
Unlike the IRR, the MIRR uses the reinvestment rate for positive cash flows and the financing rate for the initial outflows.
A) Reinvestment Rate
The reinvestment rate refers to the company’s weighted average cost of capital or WACC. The WACC is the function of the weighted average of the cost of equity and the cost of debt.
The factors that can influence the WACC are interest rates, taxes, market, and economic conditions, as far as external factors are considered, and capital structure, dividends policy, and investment policy relating to the internal company-specific factors.
B) Financing Rate
The financing rate is the rate that is obtainable for earning interest on cash outlays, or negative cash flows. This is the rate that ensures liquidity and makes investments available to withdraw at short notice. The financing rate is also associated with lower risk.
The drawbacks of MIRR include:
- Subjectivity and various assumptions in the calculation of WACC, which can influence the results.
- Difficulty when assessing the value of mutually exclusive projects/investments
- The complex nature of the concept can be more challenging to work with for someone who doesn’t have a financial background.
The profitability index, or PI, indicates the profitability and attractiveness of the investment in a project. The PI is the expressed ratio of the present value of discounted future cash flows to the initial invested capital.
Just like the NPV, the PI uses discounting and incorporates the TVM. The index is a good indicator of whether a project creates or destroys company value.
This capital budgeting and investment appraisal technique divides the present value of all estimated future cash flows by the projected initial outflows.
A PI of 1 indicates value creation and profitability. The higher the PI, the more profitable the venture is.
The index assigns value to a project for every dollar invested. A below 1 ratio (PI can't be a negative number) suggests that the investment doesn’t create enough or as much value in order to be considered.
As with other capital budgeting techniques, the PI has downsides:
- Uncertain estimates about future cash flows due to changing business and broader market and economic conditions.
- The index is oriented more towards short-term considerations rather than long-term outlook. This can produce missed or overestimated opportunities.
- Sunk costs, such as R&D, are excluded from the calculation.
- The costs of foregoing an opportunity that could generate better returns are called opportunity costs. They may be difficult to estimate or are sometimes excluded from the calculations, thus distorting results.
- Cognitive biases, such as an optimism bias, can influence the decision-making of people close to the project - this factor may lead to irrational and/or more emotion-based decisions that are not necessarily profitable and viable.
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It is an easy-to-use and understood investment appraisal technique, used in corporate finance, that provides the time period over which an investment will be returned. It has limited practicality in investment decision-making and shouldn’t be used in isolation.
The benefits it has can be layered and complimented by the other capital budgeting measures for assessing a project's risk, profitability, attractiveness, and viability.