Reviewed by Aug 27, 2020| Updated on
The payback period is the time taken to recover an investment's initial investment. It is the number of years to repay the initial investment made for a project. Hence the payback period would be used as a tool in capital budgeting to compare projects and calculate the period in years to get back the initial investment. The project is usually chosen with the lowest number of years.
The payback period is a basic time-calculation for returning the initial investment.
The payback method ignores the time value of money. All other capital budgeting strategies accept the idea of the time value of assets. Time value of money means today's rupee is worth more than tomorrow's rupee. Other methods thus discount potential inflows and arrive at reduced flows.
It is used along with other capital budgeting techniques. The payback period can not be the only strategy used to determine the project to be chosen, regardless of its simplicity.
The payback method is the easiest way of evaluating different projects/investments, and this is based on the Liquidity principle. The project is chosen, which provides a faster return on investment. More liquidity means more funds available to invest in more projects. The management uses this to get a fast review of the project.
Individuals use the payback approach to evaluate investment decisions, too. It is based on a fundamental need to at least recapture how much was spent. Indeed, even as individuals when we invest in securities, our first concern about mutual funds is always about the time frame during which we can get back our invested capital. So, it is simple and easy to understand.
This approach does not consider the time value of money, it considers all flows in parallel. For example, Rs.10,00,000 invested annually to make an Rs.1,00,00,000 investment over ten years may seem profitable today, but the same 10,00,000 won't hold the same value ten years later. The method also fails to take into account the cash flows that post the return on investment. Some projects may generate higher cash flows during the project's later life.