Budgeting Basics and Beyond

20.2. Payback Period

Payback is the number of years it takes to recover an initial investment. Payback assists in evaluating a project 's risk and liquidity, faster rate of return, and earlier recoupment of funds. A benefit of payback is that it permits companies that have a cash problem to evaluate the turnover of scarce resources in order to recover, earlier, those funds invested. In addition, there is likely to be less possibility of loss from changes in economic conditions, obsolescence, and other unavoidable risks when the commitment is short term.

Supporters of the payback period point to its use where preliminary screening is more essential than precise figures, in situations where a poor credit position is a major factor, and when investment funds are exceptionally scarce. Some believe that payback should be used in unstable, uncertain industries subject to rapid technological change because the future is so unpredictable that there is no point in guessing what cash flows will be more than two years from now.

A company may establish a limit on the payback period beyond which an investment will not be made. Another business may use payback to choose one of several investments, selecting the one with the shortest payback period.

Advantages of Payback

• Easy to use and understand

• Effectively handles investment risk

• Good approach when a weak cash-and-credit position influences the selection of a proposal

• Can be used as a supplement to other more sophisticated techniques, since ...