Investment appraisal techniques
Payback period is a simple technique for assessing an investment by the length of time it would take to repay it. It is usually the default technique for smaller businesses and focuses on cashflow, not profit.
For example, if a project requiring an investment of £100,000 is expected to provide annual cashflow of £25,000, the payback period would be four years. Similar calculations can be used to work out the payback period for a project with uneven annual cash flows.
Payback period is a widely used method of assessing an investment. It is easy to calculate and easy to understand. By focusing on projects which offer a quick payback, it helps you avoid giving too much weight to risky, long-term projections.
Disadvantages of payback period
Payback period ignores the value of any cashflows once the initial investment has been repaid. For example, two projects could both have a payback period of four years, but one might be expected to produce no further return after five years, while the other might continue generating cash indefinitely.
Although payback period focuses on relatively short-term cashflows, it fails to take into account the time-value of money. For example, a £100,000 investment that produced no cashflow until the fourth year - and then a payback of £100,000 - would have the same four-year payback period as an investment that produced an annual cashflow of £25,000.
A more complex version of payback period can be calculated using discounted cashflows. This gives more weight to cashflows you expect to receive sooner - see discounting future cashflow.