The payback period is a technique that is usually employed by financial professionals, investors and companies to determine investments yields. It is used to determine the length of time it will take to cover the initial costs of an investment. This measure is helpful prior to making any decision, particularly when investors need to make an instant decision on an investment.
You can calculate the time to payback applying the following formula:
Payback Period=Cost of InvestmentAverage Annual Cash FlowPayback Period=Average Annual Cash FlowCost of Investment
The lower the rate of return greater the value of the investment.
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Payback Period and Capital Budgeting
There’s a problem in the calculation of the payback period. In contrast to other methods for capital budgeting calculation of the payback period doesn’t take into account what is known as the the value over time (TVM). It is the notion that money today is worth more than what it would be worth in the near future due to the earning potential of cash in the present.
Many capital budgeting formulas including NPV, IRR, and discounted cash flow, think about the TVM. Therefore, if you decide to pay an investor today, you should include the expense that is not a cost of opportunity. This is known as the TVM is a term which assigns a value the opportunity cost.
The payback time period does not take into account the value of money over time and is determined by calculating the length of time it takes to pay back the amount put into the investment. For instance If the investment takes 5 years pay back the investment cost The payback time will be five years.
Example of Payback Period
Here’s an example that can illustrate how the payback time is carried out. Consider that Company A invests $10 million in a project supposed to save the company around $250,0000 every year. If we divide the $10 millions by 250,0000 we come at a payback time in the range of 4 years.
What Is a Good Payback Period?
The most efficient payback time is the shortest timeframe that’s feasible. Repaying or recouping the cost that was initially incurred by an investment or project should be accomplished as swiftly as time permits. However there are exceptions to this rule. Not all projects or investments are on the same time timeline, therefore the most short time to payback must be considered within the wider perspective of the time horizon. For instance the payback time for the home improvement project could be decades , while the payback period for construction projects can be as short as five years.
Conclusion
The payback period is the length of time needed to reach a point of breakeven for an investment. The ideal time frame for an investment can differ according to the nature of project or investment as well as the expectations of those who will be undertaking the project. Investors could use payback combination and returns on investments (ROI) to determine whether or not they should invest or participate in a trade.