What is a payback period?

The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years. This period does not account for what happens after payback occurs.

What is the difference between a short and long payback period?

Shorter paybacks mean more attractive investments, while longer payback periods are less desirable. The payback period is calculated by dividing the amount of the investment by the annual cash flow. Account and fund managers use the payback period to determine whether to go through with an investment.

What is the payback period for company XYZ?

So, the formula for the payback period goes as follows: Assume Company XYZ invests $3 million in a project, which is expected to save them $400,000 each year. The payback period for this investment is 7 and a half years - which we calculate by dividing $3 million with $400,000, using the formula shown below:

Should a business entity take investment decisions based on payback period?

However, the business entity should not take investment decisions simply on the basis of the Payback Period of the investment proposals given the inherent drawbacks of the Payback Period Method. As mentioned above, Payback Period Method neither takes time value of money nor cash flows beyond the payback period into consideration.