In this article, we’re going to talk about the payback method which is a means of evaluating investment opportunities and whether or not to accept a project. So the first step with the payback method is we’re going to calculate the payback period and what that means is we’re calculating for a given investment how long it’s going to take **to recoup** our investment.

If we invest **$100,000** how long is it going to take for this investment to pay us that **$100,000 **back and then once we know what this** **payback period is **how quickly the project will pay** for itself then we can move to step two.

Step two is we are going to **accept** the project if that payback period is for a shorter length of time then whatever happens to be our **required timeframe** for our firm. So let’s say for example that we require at our firm that all investments are paid back within **8 years** and then we calculate for an investment that the payback period is actually going to be**10 years** it’ll take **10 years** before we get our money back on this investment. Then we would** reject **the project because the payback period is actually longer than the required timeframe. As for our firm, it’s **8 years**. The required time frame is up to your firm it’s up to your CEO or your manager so this is going to vary on a firm-by-firm basis.

So let’s jump into an example it’ll make it a little easier for you to understand let’s say that

You have a company that gives hot air balloon tours and let’s say that you’re thinking about buying an additional balloon you’re saying,

“Hey you know what I actually could get another balloon and then I’d be able to give more tours and make more money”so then you say well how much would that cost buy an additional balloon? I’m not talking about replacing the balloon you already have, I’m saying buy anadditional one,one more, so let’s say that was$300,000.So you can think of this$300,000as an investment you’re making an investment and you are expecting by investing this$300,000to get anincrease in sales.I want to expect to be able to get more money from now having an extra balloon.So I want to know how quickly am I going to get my

$300,000back. First, we need to know what kind of sales increase do we expect in this case let’s say we asked me$75,0000a year now you could say let’s say for the next10 years.So for the next10 years,you’re going to get$75,000a year increased sales because of buying this balloon for$300,000and so for your company you say, “You know what I don’t want to make an investment unless it’s going to pay for itself within5 years,if it’s not going to pay for itself within5 yearsI don’t think it’s a good investment, I don’t want to do it.”

So let’s come map out the cash flows here and then make it a little bit easier for you to understand

So you’ve got time **zero** you’re putting in negative **$300,000 **and I’m going to be getting this string here of **75,000** and this is actually going to go for **10 years** this is going to be **10 times** that it’s going to actually go beyond this **year 5** but we need to know within this time frame between years times** zero** which is just the beginning and **year 5** will we have collected **$300,000**? will we have earned an extra **$300,000 **in sales to at least **break even** to get that **$300,000 **back?

Right now you might say “Well we’re going to do this for 10 years so just take 10 times 75,000 that’s **750 grand** that’s more than **300,000** right? So that’s not how it works **forget what happens after year 5.** We just want to know before **year 5.**

So what we can do is let’s just take the **cost of the investment** which is going to be** $300,000** that’s the cost of the balloon now we take that and we divide it by the **incremental sales** that we’re experiencing each year so our annual increase in sales is **$75,000 **so we divide **300,000** by **75,000** and that is going to give us **4.**

So what does that mean? That means it will take **4 years** to **recoup this investment**. So think about it we put up **300,000** and we’re saying that we’re going to get an extra **75 grand** a year and after **4 years** the investment will have paid itself back. So let’s take that** 75,000** and multiply it by** 4**. What does that give us that gives us **300,000,** what is **300,000?** That’s the exact amount that we invested in. Basically, we’re saying look if we’re going to get an extra **75000** a year it will take **4 years.**

So at this point in time, we have already paid back our investment we’ve earned the money back now we say “well does that meet the specified time frame”? We have said that the payback period is less than the required time frame, while the quired time frame, in this case, is **5 years** but we’ve paid it back here at end of **year 4. **

So what does that mean? That means that we’re going to **accept** this project because the payback period is** 4 years** which is less than our required time frame to pay back our investments which were **5 years**. So this is** 4 years** is less than the **5** that’s required so we** accept**.

### Now there are some important caveats with this payback rule:

Now it’s very simple to use and that’s why a lot of firms will use this payback method but it doesn’t give any account to the **time value of money.** If we’ve gone through net present value and things there time value of money is a very important concept in finance. So **$75,000** that’s four years from now that’s not worth the same as **$75,000** today.

Now if you don’t understand why we’ve our article on time value of money you can check out but it is just sufficient to say that the payback method just completely ignores that it **ignores time value of money** and it also **ignores the cash flow after the payback period.**

So in this case in our example we said that we’re going to gain this extra **75,000** a year for **10 years** well what if that we’re evaluating a different project that had everything else the same except that it was **30 years.** Now if we were to do the payback method for each one we would come out with **accepting** in each case now you might say “well **accept** each project,” but what if we only had **300,000** dollars to invest? Then we’re saying well look now we’ve got this **mutually exclusive investment opportunity** we can only take one of the two and if the payback would say “look they both payback within **4 years** **accept** both.” So it really doesn’t take into consideration the fact that cash payments may be taking place after this time frame and we’re not even thinking about that we’re just thinking if this thing paid back and how quickly.

So another thing about payback that really is a drawback to it is that it’s just completely **arbitrary **when we think about this **payback period**. For example, we say “well we want investments to be paid back within **5 years” **well why **5 years?** why not **6 years?** why not five and a half years? why not **4 years**? and we’re really not thinking about any of these things.

So these are very important topics. So you might be wondering why do people even use payback at all? It seems like we should really be using** net present value** as net present value is the optimum or the **optimal decision rule **when we decide whether or not we want to** accept** a project you want to be thinking about **NPV** and sure you can have** an internal rate of return** as important metric too and you can use that in many instances but NPV is where the buck stops in terms of investing and deciding whether or not to do investment.

So this payback period it’s got all these problems but people really like its **simplicity **and so it’s not just that people might be lazy and don’t feel like finding NPV in some cases you might have something where it’s kind of like a **trivial investment** or a** small investment** and it’s not something where you’re really going to go and calculate out discount rate is and all these different things.

Maybe you’re thinking of buying a copy machine or something like that you’re like “look we’re not going to do NPV all the time it would take to do NPV would actually be more time-consuming more costly than just a simple payback method and see how quickly we’re going to get our money back from this investment” so really the chief advantage to it is** simple**. But if it’s any kind of decision that you’re making on a project that is really important you should be using **Net Present Value.**