The payback method is the simplest way of looking at one or more major project ideas. It tells you how long it will take to earn back the money you'll spend on the project. The formula is:
Thus, if a project cost $50,000 and was expected to return $12,000 annually, the payback period would be $50,000 ÷ $12,000, or 4.16 years.
If the return from the project is expected to vary from year to year, you can simply add up the expected returns for each succeeding year, until you arrive at the total cost of the project.
For example, in our previous cash flow example, the project costs $100,000 and the expected returns were as follows:
The project would be completely paid for about 10 1/2 months into the fourth year, because $100,000 (cost of project) is equal to all of the first three years' revenues, plus $28,477. $28,477 is equal to about 10.7 twelfths of the fourth year's revenues.
Choosing among competing projects. Under the payback method of analysis, projects or purchases with shorter payback periods rank higher than those with longer paybacks. The theory is that projects with shorter paybacks are more liquid, and thus less risky — they allow you to recoup your investment sooner, so you can reinvest the money elsewhere. Moreover, with any project there are a lot of variables that grow increasingly fuzzy as you look out into the future. With a shorter payback period, there's less of a chance that market conditions, interest rates, the economy, or other factors affecting your project will drastically change.
Generally, a payback period of three years or less is preferred. Some advisors say that if the payback period is less than a year, the project should be considered essential.
There are a couple of drawbacks to using the payback period method. For one
thing, it ignores any benefits that occur after the payback period, so a project
that returns $1 million after a six-year payback period is ranked lower than a
project that returns zero after a five-year payback. But probably the major
criticism is that a straight payback method ignores the time
value of money. To get around this problem, you should also consider the net
present value of the project, as well as its internal
rate of return.