Introduction
The payback period is a capital budgeting technique used to evaluate the time it takes for an investment to recover its initial cost from its cash inflows. It is a simple and widely used method to assess the risk and liquidity of investment projects. This article defines the payback period, explains how it is calculated, and outlines its acceptance criteria.
Definition of Payback Period
Payback Period: It is the length of time required to recover the original investment made in a project from its net cash inflows. In simpler terms, it tells how quickly the invested money will return.
Formula:
- For Equal Annual Cash Inflows:
Payback Period = Initial Investment / Annual Cash Inflow - For Unequal Cash Inflows:
Add yearly inflows until the total equals the original investment.
Example 1: Equal Cash Inflows
Initial Investment: ₹1,00,000
Annual Cash Inflow: ₹25,000
Payback Period: ₹1,00,000 / ₹25,000 = 4 years
Example 2: Unequal Cash Inflows
Investment: ₹1,00,000
Yearly Cash Inflows:
Year 1 – ₹30,000
Year 2 – ₹30,000
Year 3 – ₹20,000
Year 4 – ₹25,000
Total after 3 years = ₹80,000
Remaining = ₹20,000
Payback in Year 4 = ₹20,000 / ₹25,000 = 0.8
Total Payback Period = 3.8 years
Acceptance Criteria Using Payback Method
- Accept the project if the payback period is less than or equal to the maximum acceptable period set by the company.
- Reject the project if the payback period is longer than the acceptable period.
- Shorter payback periods are preferred because they imply quicker recovery and lower risk.
Advantages of Payback Period Method
- Simple to understand and apply
- Emphasizes liquidity and early recovery of investment
- Useful for screening high-risk projects
Limitations
- Ignores time value of money (unless modified version is used)
- Does not consider cash flows beyond the payback period
- May lead to rejection of projects with high long-term returns
Conclusion
The payback period is an important preliminary tool for evaluating investment proposals, particularly when liquidity and quick returns are critical. While it has limitations, especially in long-term profitability assessment, it remains a popular method due to its simplicity and ease of use.