Payback Period (PBP) of An Investment — Super Business Manager

Payback Period (PBP) shows the time needed to earn enough profits to repay the original cost of the investment.

Why is Payback Period (PBP) of a project important?

Payback Period (PBP) gives the length of time required for Net Cash Flows (or net profits) to pay back the initial capital cost of the investment.

How to calculate Payback Period (PBP)?

The Initial Cost of Investment which is the original amount invested in the project is also often referred to as the principal. The formula for Payback Period (PBP) is dividing the Initial Cost of Investment by Net Cash Flows Per Year:

Payback Period (PBP) in years:

	Initial Cost of Investment
Payback Period (PBP) =	━━━━━━━━━━━━━━━━━━━━
	Annual Net Cash Flows

Payback Period (PBP) in months:

	Initial Cost of Investment
Payback Period (PBP) =	━━━━━━━━━━━━━━━━━━━━	x	12 months
	Annual Net Cash Flows

Where:

Net Cash Flows = Cash Inflows – Cash Outflows

Problems may occur when forecasting the future because no one can predict what and how external forces will affect cash flows. This can make cash flow projections inaccurate. Therefore, managers must take this into consideration.

Examples of calculating Payback Period (PBP)

A. Payback Period (PBP) of projects with even cash flows.

Example 1: A small firm is planning to buy a new printing machine at a cost of USD$20,000. It will bring in USD$5,000 in net profit each year. What would the Payback Period (PBP) be?

Let’s work out the Payback Period (PBP) in years:

	USD$20,000
Payback Period (PBP) =	━━━━━━━━━━	=	5 years
	USD$4,000

The Payback Period (PBP) for this investment is 5 years, or 60 months.

Example 2: A small business is considering the purchase of new photocopier equipment at a cost of USD$10,000. The anticipated financial gain is USD$6,000 per year in net earnings after installation and maintenance costs are paid for. What would the Payback Period (PBP) be in months?

Let’s work out the Payback Period (PBP) in months:

	USD$10,000
Payback Period (PBP) =	━━━━━━━━━━	x	12 months = 20 months
	USD$6,000

The Payback Period (PBP) for this investment is 20 months, or 1 year and 8 months.

B. Payback Period (PBP) of projects with uneven cash flows.

A business is thinking about purchasing a new machine at a cost of USD$500,000. The machine is going to be used for four years and bring in USD$700,000 in net profits. The annual Net Cash Flows are showed below. What would the Payback Period (PBP) be?

In Year 1, the Net Cash Flow is USD$300,000.

In Year 2, the Net Cash Flow is USD$150,000.

In Year 3, the Net Cash Flow is USD$150,000.

In Year 4, the Net Cash Flow is USD$100,000.

Now, we should work out the Payback Period (PBP) on the Cumulative Net Cash Flow over the duration of the project as a whole.

In Year 0, the Net Cash Flow is -USD$500,000, so the cumulative Net Cash Flow is -USD$500,000.

In Year 1, the Net Cash Flow is USD$300,000, so the cumulative Net Cash Flow is -USD$200,000.

In Year 2, the Net Cash Flow is USD$150,000, so the cumulative Net Cash Flow is -USD$50,000.

In Year 3, the Net Cash Flow is USD$150,000, so the cumulative Net Cash Flow is USD$100,000.

In Year 4, the Net Cash Flow is USD$100,000, so the cumulative Net Cash Flow is USD$200,000.

The running total of Net Cash Flow becomes less and less negative over time as further Net Cash Flows are received by the business.

The cumulative Net Cash Flow becomes positive in Year 3. This means that the investment has been paid back in full before the beginning of Year 3 which is the latest year. Let’s figure out when exactly in Year 2 the project had been paid back.

At the end of Year 2 there is still USD$50,000 need to pay back the remaining amount of the original investment.

In order to find out the exact length of time needed in the latest year when the project pays back its original investment, use the following formula:

Additional Net Cash Flow Needed
━━━━━━━━━━━━━━━━━━━━	x	12 months
Net Cash Flow in the Latest Year

A total of USD$150,000 is expected to be received in Year 3.

So:

USD$50,000
━━━━━━━━━━	x	12 months = 4 months
USD$150,000

The Payback Period (PBP) for this investment is 2 years and 4 months, or 28 months.

C. Payback Period (PBP) of many projects with different cash flows.

Two partners are planning to start a small farm to plant fruits and vegetables. In order to do so, they need to buy a piece of land. There are currently four different locations that they consider with a suitable land available – Location A, Location B, Location C and Location D. Each investment has a different Payback Period (PBP). Which location should they chose for their farm?

Payback Period (PBP) in Location A = 5 years, or 60 months.

Payback Period (PBP) in Location B = 6 years, or 72 months.

Payback Period (PBP) in Location C = 7.5 years, or 90 months.

Payback Period (PBP) in Location D = 4.5, or 56 months.

Based on the abovementioned Payback Periods, the partners should purchase the land in Location D because it has the shortest Payback Period (PBP) which is 4.5 years, or 56 months. The shorter the payback period time, the better the investment, under the Payback Period (PBP) method.

D. Payback Period (PBP) of many projects considering the time value of Net Cash Flows.

The shorter the payback period, the better the investment, under the payback method. We can appreciate the problems of this method when we consider appraising several projects alongside each other.

	Project:	1	2	3	4	5	6
Year
0		-$50	-$100	-$10	-$100	-$100	-$100
1		$5	$70	$50	$40	$30	$25
2		$10	$20	$20	$30	$30	$25
3		$15	$10	$30	$20	$10	$15
4		$20	$10	$20	$10	$10	$40
5		$20	$20	$5	$20	$40	$20
6		$10	$20	$10	$40	$30	$10
	PBP:	4 years	3 years	3 years	4 years	3 years	3.4 years

The Payback Period (PBP) is three years for three of the projects (Project 2, Project 3 and Project 5) out of six projects in total. We can claim that in this case, then, the three projects are of equal merit. However, the firm can only choose one of those projects to invest in. Which one should they choose?

In this situation, business managers must face the real problem posed by the Payback Period (PBP) method – the time value of Net Cash Flows. Put simply, this issue relates to the sacrifice made as a result of having to wait to receive the funds. In economic terms, this is known as the opportunity cost.

So, because there is a time value constraint here, the three projects cannot be viewed as equivalent anymore. Project 2 and Project 3 are better than Projects 5 because the business received net profits quicker. In the first two years, Project 2 receives USD$80 and Project 3 receives USD$70 while Project 5 receives only USD$60.

Then, when we compare Project 2 with Project 3, it is obvious that Project 2 is better than Projects 3. It is because of the earlier flow of larger net profits worth USD$70 in Year 1 for Project 2 comparing with only USD$50 for Project 3.

Comment on the result of Payback Period (PBP)

Time to pay back the investment. While paying back the original cost of an investment in 24 months or 48 months might be acceptable to consider, the business will perhaps not want to purchase something that will become old and obsolete before the payback period. Unless it is necessary to carry the production process. Therefore, the firm will tend to consider investment projects that have a relatively short payback period.

Stability. In reality, it is unlikely that the Net Cash Flows will be constant every year during the lifetime of an investment. In this case, businesses will be calculating Payback Period (PBP) using the cumulative Cash Flow method to see the total cash returns rather than focusing on annual net profits.

Cost of capital. Very often, businesses will borrow finance for their investments. This means that interest on loans must be paid. The shorter the payback, the smaller the interest payments. The longer the payback, the larger the interest payments. However, even if the investment money was obtained internally (there are no interest payments to the outside creditors) the internal investment capital still has an opportunity cost. As it could have been used for other purposes such as funding other projects, hiring more workers, training, etc. There will be an opportunity cost of money. The shorter the payback, the quicker the capital is made available for other projects. The longer the payback, the slower the capital is made available for other projects.

Uncertainty. The longer into the future before an investment project pays back the whole original capital invested in it, the more uncertain the whole investment becomes. It is because there are many unpredictable external factors that could cause problems. For example, the changes in prices of raw materials and components could make a project unprofitable. And these changes are likely to be of much greater uncertainty over ten years than over two years. Hence, the shorter into the future before an investment project pays back the whole original capital invested in it, the less uncertain the whole investment becomes.

Risk tolerance. Those managers who are ‘risk averse’ which means that they do not tolerate risk, will try to reduce risk to the minimum, So, they will be looking for projects with shorter payback periods. Faster payback reduces uncertainties as it is more predictable and likely to happen. Those managers who are ‘risk tolerant’which means that they tolerate risk, will not try to reduce risk to the minimum, So, they will be looking for projects both with shorter and longer payback periods.

Time value of money. Managers often compare the payback periods to alternative projects in order to rank them in priority order. We know that Net Cash Flows received in the future tend to have less real value than Net Cash Flows received today. This is due to inflation. Therefore, long paybacks can reduce the value of money by inflation. The slower money is returned to the company, the lower will be its real value. The quicker money is returned to the company, the higher will be its real value. Money is cash when it comes to investing.

Payback Period (PBP) – Evaluation

Payback Period (PBP) is a very popular method of evaluating investment projects comparing project lengths and cash-flow timings. It should be considered together with Average Rate of Return (ARR) which allows for comparisons of average annual profit rates.

Advantages of Payback Period (PBP) include:

Easy to calculate, use and understand. Payback Period (PBP) is the simplest and quickest of all the five quantitative methods of Investment Appraisal. The results are quick and easy to calculate and can be easily understood by managers and other stakeholders.
Allows to compare projects. Managers can compare Payback Period (PBP) of a particular project with other alternative projects. Also, they can put different projects in rank order. The results can be used by the business to ‘screen out’ the best projects, those with the shortest Payback Period (PBP). Managers will always be looking for the quickest payback of their investments. Payback Period (PBP) can also help to eliminate projects that last too long or give returns too far into the distant future comparing different investment projects with different costs by calculating the quickest Payback Period (PBP) of each option.
Helps to decide whether to pursue the project. Alternatively, Payback Period (PBP) can be compared with a ‘cut-off’ time period that the business may have laid down. For example, the firm may not accept any project proposals that pays back after ten years. It will also help to assess those projects that will yield quick returns from investment for shareholders.
Useful for firms with Cash Flow problems. Payback Period (PBP) can be useful for firms which struggle with Cash Flow problems. Illiquid businesses will be now able to identify how long it would take for the cash to be recouped. In the Payback Period (PBP) method, emphasis is on speed of returns of Net Cash Flows providing the benefit of concentrating on the more accurate short-term cash forecasts. It is definitely useful for the businesses where liquidity is more important than profitability of the investment.
Shows if the project becomes profitable before the asset becomes obsolete. Payback Period (PBP) allows a business to see whether it will break even on the purchase of the Fixed Asset before the asset needs to be replaced. This kind of knowledge can be important especially in very fast-paced business environments such as in the technology sector. In a business environment of rapid technological change, new plants and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential for firms to remain competitive.
Fewer forecasting errors. As Payback Period (PBP) assess the short-term time horizon, it will be less prone to error. However, many profitable opportunities for long-term investment are overlooked because they involve a longer wait for earnings to flow.

Disadvantages of Payback Period (PBP) include:

Not comprehensive enough to make final investment decisions. Payback Period (PBP) should only be regarded as one of the first methods to assess competing investments. It could be used as an initial screening tool to include and eliminate certain projects, but it is inappropriate as a basis for making any sophisticated investment decisions.
Focuses on time only rather than profits. This Investment Appraisal method focuses solely on time and not on profits which is the major objective of most for-profit businesses. Payback Period (PBP) does not measure at all the overall profitability of a project. Too much concentration on the short-term may lead business managers to reject some very profitable investments just because they take much longer time to repay the initial capital invested. Therefore, it can encourage a short-term approach to investing – focusing on the short-term benefits while ignoring the potential long-term gains.
Ignores all Net Cash Flows after the investment is paid off. Future net profits, hence cash, earned after the payback date are not taken into account. In the Payback Period (PBP) method, Net Cash Flows are regarded as either pre-payback or post-payback with the latter being ignored. It may, however, be possible for an investment to give a really rapid return of capital at the beginning, but then to offer no other Net Cash Flows, or very limited amounts.
Does not consider time value of money. Payback Period (PBP) does not consider discounting. It does not bring to the present value the future Net Cash Flows. The timing of the Net Cash Flows, hence present value of future money, during the payback period is ignored.
Difficult to accurately predict future Net Cash Flows. Yearly and Monthly Net Cash Flows are very, very unlikely to be constant. Monthly revenues, costs and profits will vary as unpredictability is the nature of business environment. For example, demand is prone to seasonal fluctuations, natural disasters happen, prices of raw materials suddenly increase due to military conflicts, etc. Hence, Payback Period (PBP) might take longer and all calculations might have errors as it is extremely difficult to accurately predict future Cash Flows, especially in the long-term perspective.
Useless to certain types of businesses. Payback Period (PBP) might not be suitable for some firms, especially those investing in the long-term perspective with projects lasting for many years, decades (e.g. airlines, airports, railway companies) or even centuries (e.g. hot spring resorts in Japan).

In summary, remember that Investment Appraisal is evaluating the profitability or desirability of an investment project. There are two ways to do it.

Quantitative Investment Appraisal is using techniques to study the financial issues of investment (think quantity in terms of percentages and money). And, Qualitative Appraisal which is studying non-financial issues that may impact an investment decision (think quality and impact).