Understanding Payback Period
The payback period is the time business owners need to recover the cost is has spent in an investment. In short, it is the amount of time required for the investment to reach its breakeven point. The payback period of an investment will have an impact on its attractiveness. The shorter the payback period is, the more attractive the investment will be (Also see How To calculate Return on Capital Employed (ROCE)? ).
The calculation of payback period will not only be helpful in the capital and financial budgeting but also can be used in other industries. For example, business owners may use it to calculate the return that some energy-efficient technologies can bring to the company. These may include equipment like solar panels, which includes the costs needed for upgrades and maintenance.
Capital budgeting is an essential component of corporate finance. All corporate financial analysts should know how they can value various operational projects and investments so that they can identify the most profitable ones they should choose. To do so, the analysts may make use of the payback period.
To calculate the payback period, you need to divide the cost of investment by the company’s annual cash flow (Also see Accounting – How to Boost Your Cash Flow). The investments with shorter payback will be more desirable. On the contrary, the longer the payback period is, the less attractive the investment will be.
However, there is an underlying problem with the calculation of payback period; that is, the payback period does not take the time value of money into account. This is different from other approaches in capital budgeting. The time value of money states that the money today has a higher value when compared to the same amount that you get in the future due to the earning potential of the present money, and most calculation for capital budgeting will consider it. Thus, if you want to pay an investor later, you should include the opportunity cost, and the time value for money is a concept which allocates an amount to it. In this case, the discounted payback period that considers the time value of money may be a more suitable approach.
The payback period ignores the time value of money. You may determine its value by calculating how many years it requires to recover the amount invested. Some of the analysts prefer using the payback period approach as it is easy to use. Also, some people would use this as an extra point of reference in the framework for capital budgeting.
As a business owner, understanding the payback period is crucial as you need to know how much time you need to recover the cost you have expensed when you make an investment. If you have any doubt about this, feel free to contact an accounting firm in Johor Bahru and let the professionals help you.