Payback period (PP)

Last updated: 17.03.2016

Payback period is the method used to evaluate investment projects. It comes out from relevant profit or cash-flows and calculates the number of years (months or other periods) during which will the invested amount be repaid from the relevant income or cash inflow. Generally, investments with shorter break-even point (i.e. payback period) are better as they represent lower risk. However, payback period shall not be the only decision criterion as profitability shall be considered as well. Therefore, this investment appraisal indicator is often combined with other indicators such as ROI, NPV or IRR.

 

The resulting payback period for the viable investment shall be shorter than:

  • payback period defined in investment directive
  • payback period of alternative projects/investments (unless the decision criterion is profitability)

 

Calculation formula

amount of the investment / annual incremental profit or cash-flow

 

Advantages

  • it is very simple
  • it is based on cash-flow (if it is) and not profit, which is easy to manipulate
  • it focuses on risk as it leads to acceptance shorter-term projects (longer projects are more risky)

 

Disadvantages

  • the investment usually generates benefits also after its payback and this cash-flow is not considered
  • timing of cash-flow is irrelevant and cash-flow is not discounted, therefore time value of money is ignored – this disadvantage can partially be resolved by Adjusted (discounted) payback period method
  • the only decision criteria is time, but the alternative projects with longer payback might have much higher return

 

 



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