payback period

Fin

the length of time it will take to earn back the money invested in a project.

EXAMPLE

The straight payback period method is the simplest way of determining the investment potential of a major project. Expressed in time, it tells a management how many months or years it will take to recover the original cash cost of the project. It is calculated using the formula:

Cost of project /annual cash revenues = payback period

Thus, if a project cost $100,000 and was expected to generate $28,000 annually, the payback period would be:

100,000 /28,000 = 3.57 years

If the revenues generated by the project are expected to vary from year to year, add the revenues expected for each succeeding year until you arrive at the total cost of the project.

     For example, say the revenues expected to be generated by the $100,000 project are:

Thus, the project would be fully paid for in Year 4, since it is in that year the total revenue reaches the initial cost of $100,000. The precise payback period would be calculated as:

((100,000 – 74,000) /(1000,000 – 74,000)) × 365 = 316 days + 3 years

The picture becomes complex when the timevalue-of-money principle is introduced into the calculations. Some experts insist this is essential to determine the most accurate payback period. Accordingly, the annual revenues have to be discounted by the applicable interest rate, 10% in this example. Doing so produces significantly different results:

This method shows that payback would not occur even after five years.

     Generally, a payback period of three years or less is desirable; if a project’s payback period is less than a year, some contend it should be judged essential.