In capital budgeting, the payback period is the selection criteria, or deciding factor, that most businesses rely on to choose among potential capital projects. Small businesses and large alike tend to focus on projects with a likelihood of faster, more profitable payback. Analysts consider project cash flows, initial investment, and other factors to calculate a capital project's payback period.
These capital projects start with a capital budget, which defines the project's initial investment and its anticipated annual cash flows. The budget includes a calculation to show the estimated payback period, with the assumption that the project produces the expected cash flows each year.
Companies often create more than one scenario, with differing initial investments or payback amounts, to choose a most-likely scenario that meets their risk level and other requirements for taking on the project.
What Is a Capital Project?
A capital project is usually defined as buying or investing in a fixed asset which, by definition, will last more than one year. Current projects last less than one year, and companies typically show these costs as an expense on the income statement, rather than as a capitalized cost on the balance sheet.
Capital projects can include any large-scale, expensive project such as the purchase of equipment for a new assembly line or construction of a new warehouse. Each project must be proven to pay for itself while also increasing production, cutting costs, or adding other specific business benefits.
Payback Period for Capital Budgeting
The definition of the payback period for capital budgeting purposes is straightforward. The payback period represents the number of years it takes to pay back the initial investment of a capital project from the cash flows that the project produces.
The capital project could involve buying a new plant or building or buying a new or replacement piece of equipment. Most firms set a cut-off payback period, for example, three years depending on their business. In other words, in this example, if the payback comes in under three years, the firm would purchase the asset or invest in the project. If the payback took four years, it would not, because it exceeds the firm's target of a three-year payback period.
Calculating the Payback Period
Most small businesses prefer a simple calculation, or approximation, for payback period:
Payback Period = (Investment Required / Annual Project Cash Inflow)
The net annual cash inflow is what the investment generates in cash each year. However, if this investment was a replacement investment such as a new machine replacing an obsolete machine, then the annual cash inflow would become the incremental net annual cash flow from the investment.
The project's payback occurs the year (plus a number of months) before the cash flow turns positive.
Let's say you have two machines in your warehouse. Machine A costs $20,000 and your firm expects payback at the rate of $5,000 per year. Machine B costs $12,000 and the firm expects payback at the same rate as Machine A. Calculate the two scenarios as follows:
Machine A = $20,000/$5,000 = 4 years
Machine B = $12,000/$5,000 = 2.4 years
With all other things equal, the firm would choose Machine B.
Payback Period as a Capital Project Decision Method
The payback period formula has certain deficiencies. For example, if you add in the economic lives of the two machines, you could get a very different answer if the equipment lives differ by several years. So, one deficiency of payback is that it cannot factor in the useful lives of the equipment or plant it's used to evaluate.
Perhaps an even more important criticism of payback period is that it does not consider the time value of money. Cash inflows from the project scheduled to be received two to 10 years, or longer, in the future, receive the exact same weight as the cash flow expected to be received in year one.
Due to the economic risk associated with the passage of time to receive the money, the formula gives a possibly more favorable result than the reality would suggest.
Last, but not least, payback period does not handle a project with uneven cash flows well. If a project has uneven cash flows, then payback period is a fairly useless capital budgeting method unless you take the next step of applying a discount factor for each cash flow.
The payback period formula's main advantage is the "quick and dirty" result it provides to give management some sort of rough estimate about when the project will pay back the initial investment. Even with the more advanced methods available, management may choose to rely on this tried and true method for the sake of efficiency.