Payback Period

The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

The calculation of the Payback Period is best illustrated with an example. Consider Capital Budgeting project A which yields the following cash flows over its five year life.

To begin the calculation of the Payback Period for project A let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year.

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime during the third year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:

Thus, the Payback Period for project A can be computed as follows:

Thus, the project will recoup its initial investment in 2.5 years.

As a decision rule, the Payback Period suffers from several flaws. For instance, it ignores the Time Value of Money, does not consider all of the project's cash flows, and the accept/reject criterion is arbitrary.