Payback Period

The payback period answers a practical question: how soon will we get our money back? It is calculated by adding up the cash an investment produces each year until the total equals the original cost.

Suppose a machine costs 50,000 and brings in 15,000 in year one, 18,000 in year two and 20,000 in year three. After two years, 33,000 has been recovered, leaving 17,000. Year three brings 20,000, so the remaining cost is covered about 85% of the way through that year. The payback period is about 2.85 years.

The method is popular because it is simple and highlights liquidity and risk: a shorter payback means money is at risk for less time. Many companies set a maximum payback period for new projects.

Its weaknesses are significant. It ignores the time value of money, treating money received in year three as equal to money today. It also ignores everything that happens after the payback point, so a project with large later profits may be rejected in favour of one that pays back quickly but earns little overall.