Why is payback period useful

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. What Is the Payback Period? Understanding the Payback Period. Special Considerations.

Example of Payback Period. What Is a Good Payback Period? Payback Period vs. Break-Even Point. Calculating Payback Period. Downsides of Payback Period. Payback Period for Capital Budgeting. Key Takeaways The payback period refers to the amount of time it takes to recover the cost of an investment or the length of time an investor needs to reach a break-even point.

Shorter paybacks mean more attractive investments, while longer payback periods are less desirable. The payback period is calculated by dividing the amount of the investment by the annual cash flow. Account and fund managers use the payback period to determine whether to go through with an investment. One of the downsides of the payback period is that it disregards the time value of money.

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Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Discounted Payback Period The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. Accounting Rate of Return ARR The accounting rate of return ARR is a formula that measures the net profit, or return, expected on an investment compared to the initial cost.

What Is Capital Budgeting? Capital budgeting is a process a business uses to evaluate potential major projects or investments. The shorter time scale project also would appear to have a higher profit rate in this situation, making it better for that reason as well. If a payback method does not take into account the time value of money, the real net present value NPV of a given project is not being calculated.

This is a significant strategic omission, particularly relevant in longer term initiatives. As a result, all corporate financial assessments should discount payback to weigh in the opportunity costs of capital being locked up in the project.

One way to do this is to discount projected cash flows into present dollars based upon the cost of capital. So a simple example of a payback period without time value of money without discounted payback would be as follows:. However, applying time value of money is a fairly simple process, and can be accomplished utilizing the discounted cash flow analysis equation:. As you can see, discounting the payback period can have enormous impacts on profitability.

Understanding and accounting for the time value of money is an important aspect of strategic thinking. Payback period as a tool of analysis is easy to apply and easy to understand, yet effective in measuring investment risk. Payback period, as a tool of analysis, is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor.

When used carefully or to compare similar investments, it can be quite useful. All else being equal, shorter payback periods are preferable to longer payback periods. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes.

For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.

Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period the period of time over which the energy savings of a project equal the amount of energy expended since project inception.

These other terms may not be standardized or widely used. The payback period is an effective measure of investment risk. The project with a shortest payback period has less risk than with the project with longer payback period. The payback period is often used when liquidity is an important criteria to choose a project.

Monthly liquidity of an organic vegetable business : Cash demand is high from April to August. The business is more likely to use payback period to choose a project. Payback period method is suitable for projects of small investments.

It not worth spending much time and effort on sophisticated economic analysis in such projects. Payback period analysis ignores the time value of money and the value of cash flows in future periods. The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.

An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

Zhuhai sea front development : Payback is the amount of time it takes to return an initial investment; however, it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost. Payback ignores the time value of money.

For example, two projects are viewed as equally attractive if they have the same payback regardless of when the payback occurs. Payback also ignores the cash flows beyond the payback period, thereby ignoring the profitability of the project.

The project that provides a faster return of investment is chosen. More liquidity means more availability of funds to invest in more projects. It is used by the management to get a quick analysis of the project. The payback method is used by individuals also to analyze investment decisions.

It is based on a very simple need to get back at least how much has been spent. In fact, even as individuals when we invest in shares, mutual funds our first question is always about the time period within which we will get back our invested money.

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