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Payback Period Definition
The payback period is the time it takes to recover the money invested in a project or investment. It does not take into account the time value of money or the expected rate of return. To incorporate these metrics, it is better to employ other methods, such as DCF (Discounted Cash Flow), NPV (Net Present Value) and IRR (Internal Rate of Return).
A Little More on What is Payback Period
Much of corporate finance is related to capital budgeting. Analysts search for a reliable method of determining if a project or an investment will be profitable. One method is to keep in view the payback period.
A number of methods for capital budgeting take the Time Value of Money (TVM) into account. It is basically a concept that money is more valuable at the present than in the future. The TVM assigns a specific value to the opportunity cost. The payback period ignores the TVM.
To calculate the payback period, divide the amount of money invested by the expected annual return.
Payback Period Example
Suppose, a company invests one million US dollars in a project which, most probably, can save 250,000 USD for the company every year. The payback period will be four years. we divide one million USD by 250,000 USD. Now, suppose, there is another project costing 200,000 USD. There are no cash savings linked to it. But the company earns an return of 100,000 USD every year for the coming twenty years, i.e. two million US dollars. We divide 200,000 USD by 100,000 USD to arrive at a two year PayBack period.
References for Payback Period
Academic Research on Payback Period
Some new views on the payback period and capital budgeting decisions, Weingartner, H. M. (1969). Management Science, 15(12), B-594. Many of the writers reject the concept of Payback Period regarding the capital budgeting, but still, companies use it for profitable earnings. This research helps to point out the issues that businesses strive to solve with the help of PBP. Its constraints and the liquidity of the firm’s asset has been covered. It is the need of the hour to understand the reason for the popularity of PBP and suggest its alternatives.
The role of the payback period in the theory and application of duration to capital budgeting, Boardman, C. M., Reinhart, W. J., & Celec, S. E. (1982). Journal of Business Finance & Accounting, 9(4), 511-522. This paper describes the role of Payback Period and presents its flaws in detail. The author suggests the measure of duration in the framework of the capital budgeting.
The IRR, NPV and Payback period and their relative performance in common capitial budgeting decision procedures for dealing with risk, Lohmann, J. R., & BAKSH, S. N. (1993). The Engineering Economist, 39(1), 17-47. This article studies the performance of 6 decisions based on the capital budgeting, including NPV (Net Present Value), IRR (Internal Rate of Return), PBP (Payback Period), the risk assessment that can be subjective or objective, etc. The Random Selection is the 6th one. The effectiveness of errors in case of risk and short recovery periods to eliminate the risk of invested capital.
Net present value and payback period for building integrated photovoltaic projects in Malaysia, San Ong, T., & Thum, C. H. (2013). International Journal of Academic Research in Business and Social Sciences, 3(2), 153. This paper investigates the Photovoltaic Systems as an alternative source of energy in Malaysia. Its application is still not on a large scale. The authors determine the Net Present Value, Price System, total cost and Payback Period. The ways have been suggested on how to minimize the cost of PV systems for its installation.
Discounted payback period-some extensions, Bhandari, S. B. (2009) J. Bus. Behav. Sci, 21, 28-38. The capital budgeting along with the Net Present Value and the Payback Period contains some assumptions, including market efficiency, no equity rationing and the surety of project life, Practically, many of these are not true. The criteria of NPV can be better for the profitability, but not for the liquidity. The writers discuss the DPP (Discounted Payback Period). He checks the validity of different economic variables in the context of DPP.
The payback period as a measure of profitability and liquidity, HAJDASIŃSKI, M. M. (1993). The Engineering Economist, 38(3), 177-191. One of the most common criteria for project estimation is the PBP (Payback Period). This paper elaborates the definition of PBP and adjusts it with the criterion of NPV. The traditional method of PBP had a few drawbacks. So, this approach is to overcome the problems.
Payback Period and NPV: Their Different Cash Flows, Ardalan, K. (2012) Journal of Economics and Finance Education, 11(2). Capital budgeting is one of the main subjects related to finance taught worldwide. It includes the NPV (Net Present Value) and the PBP (Payback Period). This study is to notice that the cash flows to the rule, in which the payback period is used, differs from cash flows on which the NPV is used.
Life-cycle cost and payback period analysis for commercial unitary air conditioners, Rosenquist, G., Coughlin, K., Dale, L., McMahon, J., & Meyers, S. (2004). This paper analyses the economic effects of energy efficiency for the unitary ACs and heat pumps used on a commercial level with respect to LCC (Life Cycle Cost) and PBP (Payback Period). The findings reveal how the savings may change among users facing various prices of electricity and other terms.
Payback period and internal rate of return in real options analysis, Alesii, G. (2006). The Engineering Economist, 51(3), 237-257. In this paper, a new way to estimate the value of the payback period has been presented. This is basically an extension of the real options model known as KT general model (Kulatilaka Trigeorgis). It also computes the IRR (Internal Rate of Return). The author explains with the help of an example related to shipping finance.
The role of the payback period in the theory and application of duration to capital budgeting: a comment, Kruschwitz, L. (1985). Journal of Business Finance & Accounting, 12(1), 165-167. The payback period is a vital tool for capital budgeting to analyse the worth of capital and investment projects. However, the investors criticise it because it cannot take into consideration all the flows of the project in the context of the current value. This article shows a statistical and analytical relation between the framework of the capital budgeting and the payback period.