Definition of payback period

Payback period is known as the length of time it takes the net cash revenue / cash cost savings of a project to payback the initial investment. From the definition, only relevant cash flows should be included within the calculation, so items such as depreciation (non-cash item) should be excluded.

The formula for payback period is as follow:

Payback period = Initial investment / Net cash inflow

It should be noted that the cash flows rather than the profits are used within the calculation, also need to ensure that the timing of the cash flows are taken into consideration.

Usefulness

Payback is often used as a first screening method for an investment, when will the initial cost be paid back? An organisation may have a target payback period, with any project taking longer than the target period being rejected. Payback also provides more focus on the earlier cash flows arising from a project, as these are both more certain and more important if an organisation has liquidity concerns.

In addition, two other advantages are that payback is easy to calculate and to understand.

There are, however, disadvantages associated with the payback method of investment appraisal:

•Cash flows after the payback period are ignored, therefore the effect of the whole project on the cash flows of the organization are not considered.

•A target is required, which can be difficult to set and is arbitrary.

•The increase / decrease in wealth of the investor arising from the project is not considered – the net present value of the project would need to be calculated to assess the effect on shareholder wealth, for example.

•The time value of money is not considered.

Definition of discounted payback period

The discounted payback is defined as the length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment. The discounted payback calculation takes into account the time value of money by discounting each cash flow before the cumulative cash flow is calculated, and determines the time at which the net present value becomes positive.

Usefulness

The time value of money is considered when using discounted payback, but otherwise the points made previously regarding the usefulness of payback hold for discounted payback as well.