When deciding between mutually exclusive projects, it is important to consider calculating the payback period to evaluate the risk of the undertakings. This capital budgeting tool analyzes the amount of time needed to have a project break even and incorporates the risk of the projects by looking at the future cash flows and the timing of the benefits.
When to Use Payback Period
The payback period is most useful when you’re deciding between multiple capital projects. It is only useful if you can estimate future cash flows. In addition, the payback period method is most helpful when liquidity is more important than profitability.
The payback period is strongest when you use it in conjunction with other capital investment tools, such as net present value or internal rate of return. Although the payback period is helpful in selecting a project, the calculation is best used to supplement other analysis focused more on long-term profitability. Use the payback method for single departments only – it struggles to incorporate all of the benefits received through an entire organization.
Calculate the payback period by dividing the initial cash outlay by the anticipated cash inflows or reductions of cash outflows. It is the amount of time required to recuperate the initial investment in a project. This investment may come in the form of actual revenue earned or in a reduction of expenses, such as more efficient operations due to an equipment upgrade.
A small business has $45,000 set aside for a capital project. One project requires all $45,000 as an initial investment, but it will result in a reduction of cash outflows of $15,000 for the next four years. Another project requires $40,000 as an initial investment and will produce cash inflows of $10,000 for the next six years.
The payback period for the first project is three years, or $45,000 investment divided by $15,000 per year of savings. The second project has a payback period of four years, or $40,000 investment divided by $10,000 per year of savings. For this reason, this method determines that the company should select the first project because it has the shorter payback period. Cash flows after the payback period are disregarded.
Advantages and Disadvantages
The payback period method is mostly used for its simplicity. After estimating the cash flows, the calculation is simple. It also has the strength of incorporating obsolescence, as longer projects are subject to higher risk. The payback period method favors shorter projects, so it incorporates the risk of not receiving the entirety of projected cash flows.
However, there are some drawbacks. The major flaw is the lack of consideration for cash flows beyond the break-even point. A project with slower cash flows may result in larger returns overall. In addition, it doesn’t factor in the time value of money, although this is adjusted for in the discounted payback period method. The payback period method relies very heavily on forecast cash flow calculations – and because of the uncertainty around these figures, the calculation is susceptible to variation.