Companies worldwide employ numerous capital budgeting techniques to help manage their finances, make important business decisions, and ensure their longevity. Among the most popular of these is the payback period technique.
This technique can be employed by a manufacturer to understand whether a new machine, such as an advanced production line or automated assembly unit, is a viable investment or by casinos when deciding whether to invest in different types of slots. However, it has some potentially costly drawbacks compared to other techniques.
Below, we’ll examine the payback period budgeting tool, how it works, any potential downsides, and what alternatives exist. So, if you’re in business and about to make an investment, reading this article should help you determine if the payback period will work for you.
What Is the Payback Period Technique?
One of many capital budgeting tools, the payback period calculates the length of time an investment will need to be held and managed to return (or pay back) its initial cost.
In simpler terms, the technique calculates the time it takes to reach a breakeven point or for an investment to pay for itself.
Knowing this information helps businesses determine whether a possible investment is worthwhile. For example, if a manufacturing company is seeking to invest in a new machine that has a lifespan of 12 years, the payback technique can be used to determine how many years it will take for the machine to pay itself off. If this length of time is longer than 12 years, it is not a worthwhile investment.
How to Calculate a Payback Period?
The calculation used to determine a payback period is relatively simple and is often performed in one of two ways. The first and easiest requires knowing the annual cash flow generated by the investment alone.
If this annual cash flow is constant, such as if you know a machine can generate 500 units of an item annually, the cash flow generated by these units will be used to divide against the initial investment amount.
An example is if a company invests £300,000 in a new machine in its manufacturing plant. If the machine can generate 400 units of product that sell for £200 per unit, the annual cash flow can be assumed to be £80,000 per year. The initial investment of £300,000 can then be divided by £80,000, leading to a payback period of 3.75 years (or 45 months). After this, the machine has paid for itself, and future earnings are profits.
The second technique is best suited if you are forecasting a variable annual cash flow generated by the machine. In this case, you will calculate the years before the machine is paid off and then divide the remaining cash of the final year by the cash flow generated in the machine’s final year.
Using the example above, the following cashflows can be projected: year one will generate £80,000, year two £60,000, year three £40,000, year four £50,000, and year five £90,000. To calculate how many years the payback period will fall into, the total amount is subtracted from the annual forecast. As such, £300,000 – £80,000 – £60,000 – £40,000 – £50,000 – £90,000 = £-20,000.
Therefore, we know that in five years, the machine will be paid off with £20,000 overpaid (if the entire cashflow of year five is taken for repayment). From this, we can take the £20,000 overpayment and divide it by the cashflow of the fifth year (£90,000): £20,000/£90,000 = .22. This is added to the initial years taken to pay back the machine (five) to give a final payback period of 5.22 years.
This method often takes into account a discount rate, which could lower the payback period’s time, but is often not considered when using the payback period technique for quick calculations.
Disadvantages of the Payback Period Technique
Despite being one of the most straightforward capital budgeting techniques for quick decisions and choosing an investment under pressure, using payback period calculations to make crucial decisions can have certain drawbacks. If not fully considered, these can have costly implications down the line.
Time Value of Money
The first disadvantage of this capital budgeting tool is that it fails to consider the time value of money. Because money is often not valued today at what it will be in the future, the time value of money considers the potential future earning potential of any money.
Because the payback period technique doesn’t account for this, it often fails to accurately account for an investment’s true profitability. This is amplified for long-term projects and investments that are likely to be held long after the payback period has ended.
Cash Flows After the Payback Period
Aside from the time value of money, payback period calculations often don’t account for any cash flow generated by an investment after it has been paid back. This could be detrimental to an investment decision if the investment is likely to be held long-term because investments with extended payback periods are often seen as unsuitable.
However, the majority of an investment’s profits may occur after it has been paid off. Not taking this into account could mean making a decision that disregards these profits and leads to missing out on them.
Oversimplification
One of the payback period technique’s hallmarks is its simplicity. But this simplicity can also be a drawback, as it reduces complex investment decisions to a single simple calculation.
As such, factors like risk, long-term growth, and profitability are overlooked by the calculation, which could lead to decisions against investments that have the potential to generate high profits in the future.
Overlooks Risk
As part of oversimplifying the payback period, risks associated with an investment can be overlooked using this technique. Variable future cash flows, changes to the market, machine breakdowns (if the investment is in a plant and equipment), and other factors could all affect a payback period.
Many people believe that a short payback period indicates a profitable venture. However, the failure to account for these risks means this is not true, and further investigation into the true risks and payback period should be undertaken and understood.
Alternatives to the Payback Period Technique
Once a payback period calculation has shown an investment to be viable, further capital budgeting techniques should be employed to confirm this. In many cases, these can be used in place of the payback period calculation to save time and get more accurate information from the onset.
The two most commonly used alternatives are the net present value (NPV) calculation and the internal rate of return (IRR) calculation. The NPV takes into account all future cash flows and discounts them at a specific rate. The IRR, on the other hand, calculates the effective return rate of an investment and is the discount rate used to make NPV calculations equal zero.
