The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it's how long it takes for the 澳洲幸运5开奖号码历史查询:cash flow of income from the investment🔯 to equal its initial cost.🐈 This is usually expressed in years.

Most of what happens in corporate finance involves 澳洲幸运5开奖号码历史查询:capital budgeting—especially when it comes to the values of investments. Most corporations will use payback perꦆiod analys🍰is in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting.

How to Analyze Payback Period

Payback period analysis is favored for its simplicity, and can be 澳洲幸运5开奖号码历史查询:calculated using this easy formula:

Payback Period = Initial Investment ÷ Estimated Annual Cash Flow

This analysis method is particularly helpful for smaller firms that need the 澳洲幸运5开奖号码历史查询:liquidity provided by a capital investment with a short pa🧸yback period. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time.

When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the 澳洲幸运5开奖号码历史查询:capital investment by the projected annual cas♋h inflows🗹 resulting from the investment.

Some companies rely heavily on payback period analysꦅis and only consider investments for which the payback period do♋es not exceed a specified number of years. So, longer investment periods are typically not desired.

Limitations of Payback Period Analysis

Despite its appeal, the payback period analysis method has some significant drawbacks. The first is that it fails to take into account the 澳洲幸运5开奖号码历史查询:time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future becaꦑuse of the present day's earning potential.

Thus, an inflow return of $15,000 from an investment that occurs in the fifth year following the investment is viewed as having the same value as a $15,000 cash outflow that occurred in the year the investment was made despite the fact the 澳洲幸运5开奖号码历史查询:purchasing power𝔉 of $15,000 is likely significantly lower after five years.

Furthermore, the payback analysis fails♋ to consider inflows of cash that occur beyond the paybaಌck period, thus failing to compare the overall profitability of one project as compared to another. For example, two proposed investments may have similar payback periods. But cash inflows from one project might steadily decline following the end of the payback period, while cash inflows from the other project might steadily increase for several years after the end of the payback period. Since many capital investments provide investment returns over a period of many years, this can be an important consideration.

The simplicity of the payback peri♕od analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.

This method also does not take into account other factors such as r𒐪isk, financing or any other considerations that come into play with certain investments.

Due to its limitations, payback period analysis is sometimes used as a preliminary evaluation, and then supplemented with other evaluations, such as 澳洲幸运5开奖号码历史查询:net present value (NPV) analysis or the 澳洲幸运5开奖号码历史查询:internal rate of return (IRR).

The Bottom Line

The payback period can be a valuable tool for analysis when used properly to determine whether a business should undertake a particular investment. However, this method does not take into account several key factors including the time value of money, any risk involved with the 澳洲幸运5开奖号码历史查询:investment or 澳洲幸运5开奖号码历史查询:financing. For this ൩reason, it is suggested that corporations use this method in conjunction with others to help make sound decisions about their investments.