In simple terms, payback period can be defined as a tool of capital budgeting which calculates the length of time required to recover the original invested amount. This period is usually expressed in years and can be calculated using simple dividing total investment on a project and annual cash inflow.
To further elaborate payback period, suppose you have invested an amount of 1000 for a project which has a return rate of 500 per year. The payback period in this case will be 2 years. The payback period of a project is used to analyze and determine the economy of a project and describes whether the project should be undertaken or not. Generally, projects with a smaller return period are recommendable as the invested cost will be recovered over a shorter period. Other advantages of payback period include: easy usage even for novice individuals having lesser financial knowledge; and the determination of time frame in which one would recover the original cost which is beneficial for newly established companies to avoid any risky projects.
Although payback period is a useful stand alone tool which can provide a clear picture about when one would get his investment back and start earning profit but there is some limitation also which are:
- It does not deal with the benefits achieved after the payback period.
- It does not account for the time value of money
- It ignores risks and other important considerations
For the reasons given above, payback period should only used for initial assessment of a project return period and it is advisable not to use this tool as the only option for making decision about investment. It can be useful to compare similar investments but for detailed and elaborate analysis some other methods like net present value or internal rate of return should also be utilized to make sure that you are investing in the right project.