Payback

Payback measures how quickly the benefits from the investment "pay back" the starting capital invested. These benefits are usually after tax cash flows.

One of the most tried and tested traditional methods for appraising capital investment proposals is the payback method.

The Pay back method can be used in two ways.

1. The company can decide only top accept investment projects that "pay back" within a predetermined time.
2. The company can select between competing investment projects by selecting those with the shortest pay back periods.

There is a strong argument for excluding working capital from payback calculations (remember we are appraising the project, not calculating how much net cash flow is generated each year).

Management want to know how quickly the project will recover at least the initial capital outlay. And working capital is (or should be) fully recovered at the end of the project. So there is a case for excluding working capital.

There are two drawbacks of the payback period arises:

1. When there is more than one investment amount (several in differing time periods), pay back becomes difficult to interpret.
2. The fundamental failure to allow for the "time value" of money. In other words, the cash flow dollars that arise during all years after year zero have different purchasing power values from the original investment dollars expended at time zero.

However in spite of these drawbacks, pay back is still widely used and applied in investment appraisal, due in part to ease of understanding, simplicity and a useful "rule of thumb" check mechanism for the many investment decisions that a company has to make.

Reference Pages

Discounted Pay Back Period