The Payback period method tells us the number of years it takes to recover the initial investment cost of a project or a performing asset which is paid back by future cash flows. In how many years the asset will pay back the initial cost spent on it.
Since the investment on an asset increase liquidity constrain, the time to retrieve the cash should be known to recover to the pre investment position of liquidity and no investment decision should made from the result due to its catch in itself.
How payback period is calculated?
Payback period can be calculated by, Initial investment of $5000
Even or equal cash flows of $2000 every year for 4 years.
Payback period formula: Initial Investment / cash flow per year
The payback period will be 2.5 years (Theoretically).
Payback period of uneven cash flows is treated the same way,
CF1: $1000, CF2: $2000, CF3: $1500, CF4: $2000
$4500 at the end of 3 years and 500/2000 which is the first quarter of the year 4. The payback period for the uneven cash flow in 3.5 years.
If the cash flows every year are the same simply dividing the initial investment by annual cash flow gives the payback period when the time value of money is not considered.
Weakness of sing payback period:
Payback period method lacks the time value of money, as the recovery is made over the years rather than in months. Another drawback of the method is no post cash flow after the period is taken into account. Eventually the measure of payback is futile to assess profitability of the project and other measures are used.
After processing the payback period, calculating the profitability of the project using NPV, IRR or Profitability Index, to ensure whether the liquidity is worth losing in order that the economic value will be reflected in the future. In the example of payback method, after the 2.5 years the cash flows are suspended from the calculation.
Discounted payback period is a better twin of the normal payback period, which includes the time value of money, but factoring for terminal cash flows are still untreated. As it is explicitly told that the payback period is not an investment measure and other methods are a perfect fit, the scope is reasonably forbidden.
What is a good payback period?
A good payback period cannot be said with one project in hand. In comparative terms payback period works wonders to reduce the opportunity cost and add value to the firm. If a project is paying well in advance than the project of the same sort, the project with less payback period is chosen. Addition in value regarding the size and return of the project is taken care by NPV, IRR and Profitability Index.