Payback Period

Payback periods are commonly used to evaluate proposed investments. The Payback Periods 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 mixed stream of cash inflow, the yearly cash inflow must be accumulated until the initial investment is recovered. Although popular, the Payback Period is generally  viewed as an unsophisticated ca[ital budgeting technique, because it does not explicitly consider the time value of money.

Decision Criteria

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 greatest than 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 payback period and the share value. It is simply a value that management feels, on average, will result in value - creating investment decisions.

Personal Finance Example 

Seema Mahdi is considering investing $ 20,000 to obtain a 5% interest in rental property. Her good friend Akbar Ahmed, put the deal together and he conservatively estimates that Seema should received between $4,000 and $ 6,000 per year in cash from her 5% interest in property. The deal is structured in a way that forces all investor 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 payback period of the range of annual after-tax cash flow :

after -tax cash flow = ( 1 - tax rate ) x pre-tax cash flow

                              = (  1- 0.25 ) x $ 4000  = $ 3000

                              = (  1- 0.25 ) x $ 6000  = $ 4500

The after cash flow ranges from $ 3000 to $ 4500. 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 

                         = $ 20.000 / $ 3000 = 6.67 years

                         = $ 20.000 / $ 4500 = 4.44 years

Because Seena 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.