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Payback in Project Management

Definition

The payback period can be defined as the length of time that is required for an

investment to have recovered its initial costs of an investment. It can also be defined as

the time period required for the amount invested in an asset to be repaid by the net cash

outflow generated by the asset.

The payback period analysis is one of the simplest methods of a given investment; it can

be expressed in years and fractions of years. Payback period analysis of a project is an

important determinant of whether to undertake the position or project as longer paybackperiods are typically not desirable for investment positions. It is uses methods to

compare multiple projects that are vying for company resources

Formula

The calculation used to derive the payback period is called the payback method .

Theand theformula to calculate payback period of a project depends on whether the

cash flow per period from the project is even or uneven. In case they are even the

formula to calculate payback period is!

Payback Period =Initial Investment/Project

Cash Inflow per Period

"hen cash inflows are uneven there is need to calculate the cumulative net cash flow

for each period and then use the following formula for payback period!

Payback Period = A !

C

In the above formula

# is the last period with a negative cumulative cash flow;

$ is the absolute value of cumulative cash flow at the end of the period #;

% is the total cash flow during the period after #

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Decision "ule

# project is accepted only if its payback period is &'(( than the target payback period.

The payback period is useful from a risk analysis perspective since it gives a quick

picture of the amount of time that the initial investment will be at risk. It tends to be more

useful in industries where investments become obsolete very quickly and where a full

return of the initial investment is therefore a serious concern.

Though the payback method is widely used due to its simplicity there are problems

associated with the payback period method; highlighted below are some of its

advantages and disadvantages!

Payback #ethod Advanta$es and Disadvanta$es

). Asset life span. If an assets useful life expires immediately after it pays back the

initial investment, then there is no opportunity to generate additional cash flows.

The payback method does not incorporate any assumption regarding asset life

span.

*. Additional cash flows. The concept does not consider the presence of any

additional cash flows that may arise from an investment in the periods after full

payback has been achieved.

+. Cash flow complexity. The formula is too simplistic to account for the multitude of

cash flows that actually arise with a capital investment. or example, cash

investments may be re!uired at several stages, such as cash outlays for periodic

upgrades. Also, cash outflows may change significantly over time, varying with

customer demand and the amount of competition.

,. "rofitability. The payback method focuses solely upon the time re!uired to pay

back the initial investment# it does not track the ultimate profitability of a pro$ect

at all. Thus, the method may indicate that a pro$ect having a short payback but

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with no overall profitability is a better investment than a pro$ect re!uiring a long%

term payback but having substantial long%term profitability.

-. Time value of money. The method does not take into account the time value of

money, where cash generated in later periods is work less than cash earned in

the current period. A variation on the payback period formula, known as the

discounted payback formula, eliminates this concern by incorporating the time

value of money into the calculation.

. Individual asset orientation. &any fixed asset purchases are designed to improve

the efficiency of a single operation, which is completely useless if there is a

process bottleneck located downstream from that operation that restricts the

ability of the business to generate more output. The payback period formula

does not account for the output of the entire system, only a specific operation.

Thus, its use is more at the tactical level than at the strategic level.

/. Incorrect averaging. The denominator of the calculation is based on the average

cash flows from the pro$ect over several years, % but if the forecasted cash flows

are mostly in the part of the forecast furthest in the future, the calculation will

incorrectly yield a payback period that is too soon. The following example

illustrates the problem.

%ummary

The payback method should not be used as the sole criterion for approval of a capital

investment. Instead consider using the net present value or internal rate of return

methods to incorporate the time value of money and more complex cash flows and use

throughput analysis to see if the investment will actually boost overall corporate

profitability. There are also other considerations in a capital investment decision such as

whether the same asset model should be purchased in volume to reduce maintenance

costs and whether lower0cost and lower0capacity units would make more sense than an

expensive 1monument1 asset.

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