The payback period is the time (expected number of years) required to earn back the amount invested in an asset from its net cashflows. The payback period formula is used to quickly estimate how much time will it take, in years, to get the initial investment back based on the expected net cashflows from the particular investment. An investment with a shorter payback period is considered to be better. The results of the payback period formula will depend on how often the cashflows are received. For example and initial investment of $10000 with cashflows of $1000 per year will result in payback period of 10 years. Some investment might not have equal and predictable cashflows and for them calculation the payback period might be more difficult based on the unpredictability of the amount and frequency of the cashflow. Investments that have larger cash inflows in the earlier periods are generally considered as better when appraised with payback period, compared to similar investments having larger cash inflows in the later periods. This also has to do with time value of money and the risk associated with longer period of time.
The formula for calculating payback period of an investment is dependent whether the cashflows are predictable and equal for the whole period of time. If the cashflows are even and predictable the formula for calculation payback period is:
Payback Period = Initial Investment/Net Cash Flow per Period
If the cashflows are uneven we need the calculate first the cumulative net cash flow for the time period and then divide the initial investment over that amount.
Payback period is very simple to calculate and its is a good way to get a simple idea whether an investment is good or not. It also can be uses as a risk measurement as it force us to focus on the cashflows and the predictability of it and the time needed for an investment to pay off. The longer it takes for an investment to return its initial investment the more risky the particular investment is. Also it provide a picture of expected liquidity and cashflows. Since the payback period measurement is basic and simple it has its disadvantages. Like for example it does not take into account the time value of money, the opportunity cost or other risk that might be associated with investing. Additionally the payback period doesn’t address the cashflows that are coming after the payback period and it might distort actual returns.