What is an Acceptable Payback Period for Your Investments?

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Investment analysis is a process that entails using available data to predict and make inferences about an intended investment.

One of the tools of investment analysis is Payback period. It is the topic of discussion of this article.

Application of investment analysis tools in the initial stages of investment serves the purpose of determining the feasibility and profitability of the investment.

A well-calculated investment has higher chances of turning out profitable. Business involves losses, but a large percentage of these can be deflected through analytical planning.

Calculating payback is part of this process.

 

What is the Payback Period?

The payback period is the length of time it takes for an investment to yield back the initially invested amount of money through cash in flows or to reach the break-even point. It can also be regarded as the time it takes for a project to pay for itself.

The break-even point is the time at which the total costs in the investment are equal to the total benefits.

In practice, the payback period is not always a definite number of years. It could be years and some months for example 3 years and 7 months.

There is no specific fixed time that a business always takes to reach break even point regarding an investment made.

This time largely depends on an interplay of economic factors that directly affect the business.

The payback method carries a time consciousness. All else being equal, investments with a shorter payback periods are preferred over those with a longer ones.

Payback method is an easy investment analysis method. Payback is calculated on investments and/or projects. It is the timeliness of the project in yielding the initially invested amount of money. Past records are a source of information on trends that can be used in getting figures to use calculation of payback.

 

Understanding the Payback Period.

Payback method is an investment analysis method that deals with calculation of the time it will take for the business to make back up the initial investment amount through the project’s cash in flows.

The payback period is the time it takes (or took) the business project to yield the amount initially invested.

The focus of this method is time. In comparing two projects for the more ‘attractive’ one, this method will choose the one that takes a shorter time to make back up the original investment amount over the other that takes a longer time regardless of whether the left out project is more income generating in the long run.

This method is centred around two paradigms; that ‘time is money’ and ‘a bird in hand is worth two in the bush.’ Earlier gains are more valued than later gains.

If the payback period is less than the maximum time allowed for realisation of cash in flows making up the invested amount, then this is considered a viable project that deserves to be invested in.

Payback period is calculated by considering cumulative cash flows over the subsequent years starting with the first year of cash in flow until the year in which the initial investment amount is made up.

How to calculate Payback period.

Year/ Project Year 0 Year 1 Year 2 Year 3 Year 4 Total amount made
Project A ($1000) $400 $200 $400 $400 $1600
Project B ($1000) $1000 $0 $0 $100 $1100
Project C ($1000) $500 $200 $100 $2000 $2800

 

The amount under the column of the initial time of investment (denoted “Year 0”) is not considered. It is actually put in brackets in this example because it is not a cash inflow but an investment into the business.

The time factor is all that matters in the Payback concept. For project A, for example, the payback period is 3 years.

In the third year is when the project hit the $1000 cumulative cash in flow amount that equals to the initial $1000 investment.

In our example above, however much project B yields the lowest overall cash in flow, it is considered as the most viable among the three and even though project C yields the highest cash in flow, it is the least ‘attractive’ according to the Payback investment analysis method.

This distinction is caused by the underlying principle of time consideration that this method bases on.

 

What is a Good or Acceptable Recovery Period?

There are a number of factors to consider in making this inference. For new start ups, the shorter the payback the better, since new start ups require more liquidity.

A shorter payback of, say 6 months, is remarkable because it makes money available to the business for other functions.

All other factors being constant, a project with payback period of more than 2 years is not recommendable because it ties up the money that would be applied to other uses.

The investment risk involved: If the initial investment amount is high, it carries with it a correspondingly high risk. It is more advisable to invest a high amount of money in projects that will pay back the original amount faster. Projects that have a longer payback on top of tying up the valuable money of the business carry a risk of money loss.

 

Is the Payback Period the same thing as the Break Even Point?

The two terms are built around the same concept but they are inherently different. Break even point is the point in time at which the investment attains a balance whereby the total costs are equal to the total revenue.

There are two types of costs incurred; fixed costs and variable costs. Fixed costs are the expenses that a business has to make regardless of its level of production.

An example of a fixed cost is rent. They are the same over every production period.

Variable costs change in sync with the level of production.

There is a direct proportionality between variable costs and the level of production.

An example of a variable cost is expenses incurred in purchasing raw materials.

The terms ‘Payback period’ and ‘Break even point’ are not freely interchangeable.

They are related in the context that payback period is the length of time required for a project to reach break even point after the initial investment has been made.

 

What are the Advantages of Calculating the Payback Period?

a) Period to attainment of safety.

Investing in a business is a risky venture. There is a possibility of losing the invested money when the project does not yield any cash in flow or the project could tie up the financial resources when it takes a long time to yield back the invested amount through cash in flows.

Calculating payback period is definitely the same as calculating the expected time that the project will return the money ‘lent’ into it via the investment made.

b) Investment decisions.

Payback is a basis for making the best investment decision that involves making a choice among alternative potential projects.

The best alternative in this context is one whose cash in flow will take less time to make up a cumulative sum equal or above the initially invested amount. Investment in business involves opportunity cost.

The money invested could be used for other alternative purposes in the business.

It is therefore important that the chosen project is one which will yield back this amount for ploughing back into the business for other uses. Payback is a measure of liquidity in the business.

c) Lending institutions

When according loans, lending institutions are interested in the payback period of the intended project.

When the postulated payback period is within the loan repayment time limit, the lender will more easily grant the loan to the business than for a project with a longer payback.

The payback period is also used by the lending institution to determine the security required for the loan and the interest to charge for the loan.

 

Payback Investment Analysis Method Has its Shortcomings:

It does not take into consideration the temporal fluctuation of the value of money.

Money value can appreciate, depreciate or remain stagnant over time.

This over-simplistic determination ignores the question of the scope of what you can do with the money after a particular period of time has passed.

It insists on a target-attainment period, ignoring cash flow beyond this. The payback method is only interested in its ideal situation of the earlier, the better.

This is illustrated in our example above, where this method selects project B over project C despite the fact that project C yields more cash in flow in the long run.

The method is a disincentive to long-term projects. If the approval of projects in the business is based on payback period, then departments with long term projects that may be more significant to the business may not stand a chance.

This is because the criterion is biased towards favouring the earliest gains.

If payback is the only consideration, a valuable project may be overlooked and its benefits missed out by the business.

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