Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash inflows. In the case of an annuity, the payback period can be found by dividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.
When the payback period is used to make accept–reject decisions, the following decision criteria apply: • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project. The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement or renewal, other), the perceived risk of the project, and the perceived relationship between the payback period and the share value. It is simply a value that management feels, on average, will result in value-creating investment decisions.
The formula in calculating payback period is:
Payback Period = Cost of Project / Annual Cash Inflows
Pros and Cons of Payback Analysis
Large firms sometimes use the payback approach to evaluate small projects, and small firms use it to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money. Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques. The longer the firm must wait to recover its invested funds, the greater the possibility of a calamity.
Hence, the shorter the payback period the lower the firm’s risk exposure. The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firm’s value. Instead, the appropriate pay-back period is simply the maximum acceptable period of time over which management decides that a project’s cash flows must break even (that is, just equal to the initial investment). A second weakness is that this approach fails to take fully into account the time factor in the value of money. Example of Payback Period
Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Her good friend and real estate agent, Akbar Ahmed, put the deal together and he conservatively estimates that Seema should receive between $4,000 and $6,000 per year in cash from her 5% interest in the property. The deal is structured in a way that forces all investors to maintain their investment in the property for at least 10 years. Seema expects to remain in the 25% income-tax bracket for quite a while. To be acceptable, Seema requires the investment to pay itself back in terms of after-tax cash flows in less than 7 years. Seema’s calculation of the payback period on this deal begins with calculation of the range of annual after-tax cash flow: After-tax cash flow=(1 -tax rate)
*Pre-tax cash flow
The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 initial investment by each of the estimated after-tax cash flows, we get the payback period: Payback period=Initial investment / After-tax cash flow
Because Seema’s proposed rental property investment will pay itself back between 4.44 and 6.67 years, which is a range below her maximum payback of 7 years, the investment is acceptable.