What is Payback Method? With Examples, Pros & Cons

The payback method assesses how long it takes to get back the initial investment. Companies use it to evaluate the speed at which projects or investments generate returns.

Understanding the payback period method, along with its advantages and disadvantages, supports more informed decision-making. This article explains the payback method, provides examples, and addresses frequently asked questions.

What is payback method?

The payback method is a method used to calculate the time required to recover the initial cost of an investment and is commonly used in capital investment appraisals.

The method finds out how many years it will take for a project's cash inflows to match the initial investment. A shorter payback period is generally preferred over a longer payback period, as it indicates a quicker return on investment (ROI) and a higher net present value.

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Payback method vs payback period

As mentioned, the payback period calculates the time it takes for an investment to repay its initial cost. The payback period formula is: Payback period = initial investment / expected annual cash flow.

The payback method, on the other hand, is a rule that favors projects with shorter payback periods, focusing on quicker recovery of the initial investment. It is commonly used to evaluate capital investments in companies, especially when liquidity and project risk are important, or when profit alone is the main factor.

In simple terms, the payback period answers "how long it takes" to recover an investment, while the payback period method favors projects with shorter payback periods for faster returns.

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Advantages and disadvantages of payback method

The payback period analysis doesn't always come with benefits and has its share of drawbacks as well.

Pros

• Simple to understand and calculate

  The payback method is straight forward and doesn’t require advanced financial skills, so most managers or team members can use it to make decisions.

• Prioritizes quick cash generation, helping liquidity

  This method shows how quickly an investment recovers its cost, which helps companies improve positive cash flow or get quick returns. It also highlights projects that generate cash quickly.

• Useful for setting investment targets and monitoring progress

  It helps businesses set clear goals, like recovering the initial capital in a set time. It also makes it easy to track a project’s progress and see if it meets financial goals.

Cons

• Overlooks time value of money, inflation, and opportunity cost

  A major disadvantage of the payback is that it doesn’t consider the time value of money. It treats future, positive cash flows the same as today’s, ignoring inflation and the cost of choosing a particular investment over another.

• Bias towards quick paybacks over overall profitability

  It favors quick returns, even if these projects are less profitable in the long run. This can lead to prioritizing short-term cash flow over more profitable, long-term investments.

• Focuses only on payback period cash flows, excluding long-term profits

  The method only focuses on recovering the initial investment and ignores average cash flows after that. This means it doesn’t show the full profitability of a project, potentially missing more profitable long-term opportunities.

Payback method examples

To fully understand the method, let's consider these two scenarios:

Scenario #1

A company is considering purchasing a $6,000 printer to increase the speed of its printing services. The printer is likely to last five years. Each year, it is projected that the printer will generate an additional $1,500 in revenue, as it allows the company to handle more printing orders.

To calculate the payback period, the initial $6,000 investment is divided by the annual cash flow: Payback period = 6,000 / 1,500 = 4 years

In this example, the payback period is 4 years, meaning the company will recover its $6,000 investment in that time. Since the printer lasts 5 years, the company will recover the cost before the printer's life ends, but the total return is still unknown.

Scenario #2

Imagine a business planning to invest $50,000 to upgrade its internet cafe by purchasing 20 high-performance gaming PCs, each priced at $2,000, and spending an additional $10,000 on high-speed internet installation and furniture. The business expects to earn $20,000 in annual revenue from the gaming PCs, factoring in hourly usage fees, memberships, and events.

To calculate, the total $50,000 investment is divided by the expected annual revenue: Payback period = 50,000 / 20,000 = 2.5 years

This means the business will recover its initial investment in about 2.5 years. However, since gaming PCs typically last around three years before needing upgrades, the business should consider future costs when evaluating the investment's long-term value, which is one of the limitations of the pay period analysis.

The same issue can happen with hiring: if you don’t hire the right people, it can affect long-term success. Just as businesses invest in equipment, companies can find skilled candidates using Real-time Job Posting Salary Data solution to add lasting value.

How to calculate payback period

As mentioned, calculating the payback period is easy; simply follow these steps:

1. Determine initial investment: Find the total amount of money invested. Let's say a café invests $3,000 in a new coffee machine.

2. Estimate annual cash inflows: Calculate the expected yearly cash flows from the investment. For this example, the café expects the new machine to generate an additional $1,000 in profits each year.

3. Apply the formula: For payback period calculation, here's the formula: Payback period = Pay period = initial investment / expected yearly cash flow. For example, if the café invests $3,000 and expects $1,000 in yearly cash flow: Pay period = 3,000 / 1,000 = 3 years

In this case, the café will take 3 years to get back its initial investment.

FAQs

Here are some common questions about the payback method:

What is a major advantage of the payback period method?

Its main advantage is its simplicity. It quickly shows how long it takes to recover the initial investment, which helps in making fast decisions. The method is easy to understand and doesn't need complex calculations.

When to use payback method?

The payback method is best for quick decisions, especially when it's important to get the initial investment back fast. It's also useful for small businesses or start-ups with limited cash, or in uncertain, high-risk situations.

Who uses the payback method?

As mentioned, the payback period method is used by small businesses, start-ups, and companies that prioritize liquidity and quick recovery of investment. It's also favored by managers and investors working in high-risk or uncertain environments where rapid returns are critical.