What is the recovery period?
The payback period refers to the time it takes to recover the cost of an investment. In other words, the payback period is the period during which an investment reaches a breakeven point.
The advisability of an investment is directly linked to its payback period. Shorter depreciation means more attractive investments.
[Important: Investors and managers can use the payback period to make quick judgments on their investments.]
The concept of payback is commonly used in financial and capital budgeting. But it has also been used to determine the cost savings of energy efficiency technology.
Understanding recovery periods
Financing businesses is a matter of investment budget. One of the most important concepts that every corporate financial analyst should learn is how to assess different investments or operational projects. The analyst must find a reliable way to determine the most profitable project or investment to undertake. One way for corporate financial analysts is the payback period.
The payback period is the cost of the investment divided by the annual cash flow. The shorter the return on investment, the more desirable the investment. Conversely, the longer the return on investment, the less desirable it is. For example, if installing solar panels costs $ 5,000 and the savings are $ 100 each month, it would take 4.2 years to reach the payback period.
But there is a problem with the recovery period. It ignores the time value of money (TVM), unlike other investment budgeting methods such as net present value (NPV), internal rate of return (IRR) and discounted cash flows.
While payback periods are useful in financial and capital budgeting, it has applications in other industries. It can be used by homeowners and businesses to calculate the performance of energy-efficient technologies such as solar panels and insulation, as well as maintenance and upgrades.
Capital budgeting and payback period
Most capital budgeting formulas take into account the time value of money (TVM). It is the idea that money today is worth more than the same amount in the future due to the earning potential of current money. Therefore, if you pay an investor tomorrow, it must include an opportunity cost. The time value of money is a concept that places a value on this opportunity cost.
The payback period, however, does not take into account the time value of money. It is determined by counting the number of years necessary to recover the funds invested. For example, if it takes five years to recover the cost of the investment, the payback period is five years. Some analysts favor the recovery method for its simplicity. Others like to use it as an additional point of reference in an investment budgeting decision framework.
The payback period ignores what happens after the payout, ignoring the overall profitability of an investment. Many managers and investors therefore prefer to use the NPV as a tool for making investment decisions. The NPV is the difference between the current value of incoming money and the current value of outgoing money over a period of time.
Key points to remember
- The payback period refers to the time it takes to recover the cost of an investment or the time it takes an investor to reach break even.
- Account and fund managers use the payback period to determine if an investment should be made.
- Shorter depreciation means more attractive investments while longer depreciation periods are less desirable.
- The payback period is calculated by dividing the amount of the investment by the annual cash flow.
Example of a payback period
Suppose Company A invests $ 1 million in a project that should save Company $ 250,000 each year. The payback period for this investment is four years, dividing $ 1 million by $ 250,000. Consider another project that costs $ 200,000 with no associated cash savings, which will make the business an additional $ 100,000 each year for the next 20 years at $ 2 million. Obviously, the second project can bring in twice as much money to the company, but how long will it take to pay off the investment?
The answer is found by dividing $ 200,000 by $ 100,000, or two years. The second project will take less time to pay back and the company’s profit potential is greater. Based only on the payback method, the second project is a better investment.