Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash inflows. In the case of an annuity, the payback period can be found by dividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.
When the payback period is used to make accept–reject decisions, the following decision criteria apply:
• If the payback period is less than the maximum acceptable payback period, accept the project.
• If the payback period is greater than the maximum acceptable payback period, reject the project.
The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement or renewal, other), the perceived risk of the project, and the perceived relationship between the payback period and the share value. It is simply a value that management feels, on average, will result in value-creating investment decisions.
The formula in calculating payback period is:
Payback Period = Cost of Project / Annual Cash Inflows
Pros and Cons of Payback Analysis
Large firms sometimes use the payback approach to evaluate small projects, and small firms use it to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money. Because it can be viewed as a measure of risk