Payback Period Definition and Example
Payback Period Definition – “The length of time needed to recoup the cost of a capital investment”.
In simple words, it is the time period to recover the cost of an investment. Or you can say the length of time that the investment will take to repay the cash outflows while purchasing the asset. It act as a foundation for whether to go for the investment or not.
Payback period is one of the method of capital budgeting. Capital budgeting is the planning process which determines whether it is profitable to invest in the long term assets of the organisation or not. This method does not takes into consideration the time value of money. This is a non – discounted cash flow method of capital budgeting. This is also the limitation of this method.
Payback Period Formula
Case 1 – Even Cash flows
Payback period = Initial Investments / Average Cash Flows
Case 2 – Uneven Cash Flows
Pay back period = Last year of negative cash flows + ( Value of last year of negative cash flows/ value of cash flows of year where cumulative cash flows become positive)
Payback Period Example
Let’s understand Payback period definition with examples. XYZ Ltd is thinking of taking a project which requires initial investments of Rs. 2,00,000. The project is expected to generate Rs. 50,000 per year for 5 years.
So the payback = 2,00,000/50,000
= 4 years
There is a ABC company which is thinking to undertake an object of initial investment of Rs. 10,00,000. The expected inflows from the project for 5 years are – 50,000, 1,00,000, 2,00,000, 3,0000 and 3,50,000 respectively.
|Year||Cash Flows||Cumulative Cash flows|
Therefore, the payback = 2+(4,50,000/5,00,000)
Related Financial Terms of Payback Period
Advantages of Payback
- Very simple to understand and calculate.
- It acts as a tool to decide which project to choose. A higher payback period means reject the project. Lower pay back means accept the project.
Disadvantages of Payback
- The biggest disadvantage of this method is that it ignores all the inflows after the payback period.
- It does not considers time value of money.