Payback period can help evaluate potential risks and determine when a project will repay itself.
As supply chain consultants and material handling system integrators, we are often asked to evaluate the economics of capital projects. There are several metrics that can be used to evaluate a project, each with their own set of advantages and disadvantages. However, we are almost always pressed to say what the “payback period” is of a given project. Every time it happens, my stomach hurts just a little.
A Simple Financial Metric
Payback period is the financial metric that tries to answer the question: How long does it take for an investment in a project to pay for itself? Or, how long does it take for my incoming returns to cover my costs? Or, put still another way, how long does it take for the investment to break even?
Payback period is widely used because it is easily understood and, when used to compare similar investments, can be quite useful. It refers to the period of time required to “repay” the sum of the original investment. For example, a $1000 investment returning $500 per year would have a 2-year payback period.
Payback period intuitively measures how long something takes to pay for itself. Typically, shorter payback periods are preferable to longer payback periods because they are viewed as less risky. It is usually assumed that the longer the payback period, the more uncertain are the positive returns. For this reason, payback period is often used as a measure of risk. We generally see companies looking favorable on projects with a payback period of 1-3 years, with skepticism of projects over 3 years.
But consider two investments — one for $1 million and another for $100,000. The first one has a 4-year payback (I get back, on average, $250,000 each year). The second project has a 2-year payback (I get back, on average, $50,000 each year). See the problem?
No True Formula
There is no true formula to calculate a project’s payback period, except for the simplistic and unrealistic case where the project in-flows are constant (or constantly growing) and easily divisible into the initial investment. In most projects, to calculate the payback period, it is necessary to create a spreadsheet that looks at cumulative cash flow to determine the period in which it goes from negative to positive.
All things being equal (which is rarely the case), the project investment with the shorter payback period is considered the better investment. The shorter payback period is preferred because the investment costs are recovered sooner and are available again for further use.
Although the payback period is easy to understand and communicate, it has serious limitations because it does not account for the time value of money (TVM). A way around this is to use a measure for a discounted payback period.
Discounted payback period uses a discounted cash flow technique to find the time period in which the present value of future cash flows equals the initial cash outlay. However, once this metric is employed, all the simplicity of the payback period is lost. In my opinion, if you are going to go to that much trouble, there are better metrics that can be employed.
Another problem with payback period analysis is an assumption that project returns will continue even after the payback period is attained. Additionally, payback period analysis does not specify any required comparison to other investments, or even to not making an investment at all.
Fortunately, there are other, alternative measures of a project’s return to consider. Two of these are net present value (NPV) and internal rate of return (IRR). Although these metrics have problems and limitations of their own, they are much stronger economic analysis metrics.
Overall, payback period is a simple way to communicate how long it will take for an investment to be repaid. It can also be a good indicator of a project’s risks, but there are limitations to the amount of detailed information payback period can provide. To get the clearest view of a project’s potential return, you might consider calculating discounted payback period as well as NPV and IRR. Using these three metrics will provide a more detailed analysis of the risk and reward associated with your project investments.