Definition of Payback Period
The payback period is a common (but not the best) tool for screening a company's potential investments. It uses the potential investment's undiscounted cash flows to calculate the number of years it will take for the company to recoup its investment.
Example of Payback Period
Assume a company invests $100,000 in a project that is expected to have the following positive net cash inflows:
- $30,000 in Year 1
- $40,000 in Year 2
- $40,000 in Year 3
- $50,000 in Year 4
The payback period for the $100,000 investment is approximately 2.75 years ($30,000 + $40,000 + $30,000 of Year 3's $40,000).
Limitations of Payback Period
The payback period has two limitations or drawbacks:
- The net cash inflows are typically not adjusted for the time value of money. This means that a net cash inflow of $50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a $50,000 cash outflow that was part of the initial investment made four years earlier.
- The cash flows received after the payback period are ignored.
Example of Limitations of Payback Period
Assume a corporation is considering investing in one of two projects:
- Project #187 has a payback period of 4 years. However, the amounts of the net cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7
- Project #188 has a payback period of 6 years. However, the amounts of its net cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15
While Project #187's payback period is faster, Project #188 is significantly more profitable. Hence, the limitation of using only the payback period when ranking potential investments.