Payback Period Explained In Detail With Formula And Examples
If you are a person who lives on without any attachment or interest in business or its functioning, you might consider business problems as direct faults of business owners. Solely blaming them is often the knee-jerk reaction. However, the scarcity of resources induces a problem that needs to be solved. The scarcity of capital and investment are the monsters under the bed that entrepreneurs and shareholders of a business are trying to solve. Some use financial modeling or other concepts like the payback period method or analysis to figure out business problems and estimate the value gained from investment in a specific project.
And how quickly that future value materializes for the business involved. This is a method that captures heaps of value for its users but has certain shortfalls that will be discussed in detail at the end. However, formulating a payback period and analyzing business investment decisions is not an easy task. Persons involved in finance, especially corporate finance possess a forte in finance and have studied it in dozens of books for years to become professionals at their craft. So, they find little trouble in understanding the value of the payback period and the suitable conditions for its use. But if you are among the crowds of people who know little to nothing about payback periods or finance, this article is for you.
To understand the immense value derived through the payback period method and other methods of valuing financial decisions that revolve around future returns or prospects, you must digest some of the important concepts that surround it.
Initially, finance and its definitions as coupled with its primary concepts are required. Following finance, its sub-categories or areas of significance need to be learned thoroughly. This is necessary for capturing the ideas behind the concepts themselves and how they apply to valuation models and payback period analysis. Furthermore, you’ll need some insight into the major factors influencing business capital investment and debt-taking. Important terms regarding the matter are a good beginning that will lay the groundwork for further understanding.
We’ll also discuss the accounting fundamentals required for return period methodology to work effectively. Since the method is often computed using spreadsheets, a small detour from the main topic of the article will be taken as Excel functions are essential for the method at hand to function properly.
After all the foundational work is cleared, we’ll dive into the concept of the payback period method and its variations, shortly followed by the major advantages and disadvantages of the method. These will be discussed at length and will certainly provide vivid details and pragmatic answers to all your queries. Now that we have outlined the major points of discussion of our article, let us not take the first step to learn about the payback period method.
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Finance For The Layman:
Technically speaking, finance is the field of economics that deals with transactions and variables that have direct or indirect effects on money and its circulation, the currency of a country, and various economic phenomena like public debt, and expenditure.
It is a multifaceted discipline that operates on several levels of society and the economy. However, that is not easy to understand and is academically enriching but does not hold good explanatory value. While explaining any concept, the best way is often to associate it with aspects of living that form the common denominator for everyday living. Finance explained in this manner is simply the way entities save, try to invest in markets, and ride waves before they collapse or how portions of their income are spent by them.
The entity is a term that is a placeholder term for individuals, businesses, and governmental authorities. These also form the major distinctions of finance as a discipline, namely:
- Personal finance is the terminology used for finance that relates to the choices of individuals acting in self-interest to manage their income in such a way that it results in an overall increase in the wealth held by them over some time. This includes saving plans, tax rebate schemes, and comprehensive financial literacy focusing on asset creation as well as deliberate spending & consumption. Advisors who work with individuals to save wealth do so to ensure financial security and a pleasant retirement. Personal finance is an endeavor to manage risk in the short and long term while accruing wealth over time to ensure a financially sound retirement.
- Public finance may be termed as the opposite of personal finance by nomenclature, but it shares many of the same tools in its arsenal as personal finance. It also shares the concerns of personal finance and many of its principles. Where it differs, however, is in its scope and the size of its operation. It is a tool used by governmental authorities to strengthen and manage economic policy so that it can meet economic welfare for its citizenry by ingraining established economic goals into the working of the economy. It’s a procedure that stabilizes fluctuations in the economy, moves to diversify it into a variety of sectors induces investments, and inaugurates public sector undertakings in times of need. It is the lifeline of the economy that deals in grand scheme macro-variables, compared to micro variables that are considered more important under the personal finance decision-making process.
- Finally, corporate finance is the type of highest concern for us considering the title. It is the type of finance that deals with business transactions and many of the same principles as public and personal finance. It is a finance that aims to gain market share and garner the highest net profits for the business shareholders. It is an area of finance that stands at the nexus of the other two distinct categories. On one hand, it is a field that deals with creating profit so it works to cover its metrics, cut costs wherever possible and study its customer’s behavior to shape its services and products accordingly. On the other hand, businesses share the same industry and are entities that develop measures and regulations for the maximum share of profit for the benefit of individual businesses. Governmental control over profits demanded as tax and other liabilities of gaining a practicing license, abiding by the law of the land in matters of wage determination and labor treatment is another important factor. Furthermore, the unshared profits of businesses are often utilized for massive expansion, research & development, or in the improvement of production efficiencies. However, the projects undertaken require long gestation periods wherein returns to investment is nil. Under these circumstances, businesses need to know the details of returns and net profitability before initiating a project. Financial models are utilized in this case, or the payback period method as both are reliable tools for project appraisal.
The aforementioned definitions are not the most technically rich or sound but shall serve you well and are portrayed easily for natural comprehension. However, learning about these different areas of finance will be inadequate if you know little about…
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Concepts Related To Finance – Accounting & Investment
Accounting is a term that forms the commercial understanding of most high school diplomas that focus on finance. It is usually coupled with some good books of economics as well. Accounting is a massive field of business in its own right and its specific principles and concepts would engulf the space of this entire article, given the liberty.
Keeping the language of businesses to its alphabet, it is a discipline that manages business figures and information in a systematic and orderly fashion. It is practiced to render noteworthy information regarding the business’s health through numerical parameters and key financial indicators that are factored in with the idea of augmenting them in the future.
It presents the current conditions of the business through financial statements that are distributed across the country, which fall under the scrutiny of a multitude of finance professionals. Ultimately, the goal of accountancy is to secure a standard language for business processes and transactions that smoothens the way for complicated calculations and guesswork. It is a field that is essential for the payback period method to be utilized in any of its forms because of the necessary record of business metrics and figures required for computation.
Secondly, investment as a general concept is the backbone of business proliferation. It is essential for capital formation to gallop upwards and prompt a transformation of the business in the long term, increasing profit margins or total revenue in the short term. Investment is differentiated for business purposes into two distinct categories – capital investment and financial investment.
Financial investment is the simple exchange of asset ownership through the buying and selling of equity or the transactions of bonds, shares, and stocks in the open market. It is a means of investment that allows businesses access to nearly liquid assets while also aiding them in the diversification of their funds, in case of recession. It is an effective means of hedging in times of economic downturn, however, it does not create any new assets or liabilities and is only concerned with a change of ownership, not about increasing production.
Capital investment on the other hand is the major way of creating new assets by extending money to professionals for buying equipment or setting up new plants that will improve productivity in the long term. This is the kind of investment that requires project planning and valuation as…
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Payback Period: Definition & Different Types
The risk involved is far too high for normal businesses. Now, we arrive at the main topic of discussion. The payback method is utilized to estimate the cost of the project and the expected returns. Its main purpose is to calculate the period required for the principal amount invested to be fully returned to the business through profits accruing from expansion in machinery, hiring better quality workers, ironing out systemic inefficiencies, etc.
It is a method that ensures the viability of the investment option chosen and whether it is the best among the plethora of options at the disposal of business stakeholders. Capital budgeting has never been easier than when you utilize this method of project valuation. It is a method with monumental benefits and downsides as well, though it is a part of the banner of investment decision-making methods that are taken by businesses to ensure project risk and profitability. These are comprised of two distinct types of valuation methods:
Traditional methods – These are the methods that assume the constancy of pricing over time and returns on investment as well. They are often termed unrealistic but are useful in gaining an approximation of the returns and period required for breaking even for the funds invested. The methods falling under this type are:
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Payback Period Method
Accounting Rate of Return Method
- Time Adjusted or Discounted Cash Flow Method (DCF) – This type of methodology reflects the dynamic nature of money over time. It takes into account the time dimension and calculates discount ratios through a collaboration of multiple factors; accounting for realistic propositions in the business world of the modern age where changes take place in a hurry and financial cycles are hurried along by the increased flow of money. The methods that fall under this type are as follows:
- Net Present Value Calculation Method
- Profitability Index Analysis
- Internal Rate of Return Method
- Controlled/Modified IRR Method
- Discounted Payback Period Method
These are just some types of the methods used and we’ll focus on the PP methods. The discounted version of this method is extremely useful for real-world investment returns and loan return calculations. They work in entirely different ways as their formulas are as different as can be possible.
Let us take examples of both methods to instantiate the differences. Supposing the cost of a project turns out to be twenty thousand dollars, the profit of a mere three thousand dollars with the depreciation of ten percent and a tax slab of thirty percent. Under the traditional method, the PP method is formulated as a total capital investment (initial) divided by expected annual inflows after taxation. To calculate this, we can measure the PBIT as given, tax of nine hundred and depreciation of two thousand dollars. Calculating the expected inflows after tax will result in a sum of four thousand hundred dollars. Next, the calculation of the PP is easy and comes out to four points nine years approximately i.e. four years and eleven months for PP. On the other hand, DCF methods work in a completely different manner and are much more complicated with detailed calculations using different ratios, and the formula for it takes average annual cash flows
and divides them by the principal amount invested. Now that we know the different methods of payback on investment over some time, we will not squander any more time over the details of the methodology and dive straight into…
The Merits & Demerits Of the Payback Period Method:
This method is an important one for gauging the temporality of returns over time until the entirety of the initial investment is regained. It has numerous benefits attached to it that don’t seem apparent at first glance, so here we present them in their glory:
- When you look at the financial methodology and financial figures, they can look extremely daunting and overly- intricate in their natural habitats. Financial statements can be tricky to manage by themselves much less while conducting serious calculations over several years. This method is different and is simplistic and easy to comprehend by design.
- Furthermore, its simplicity drives its speed. It is a fast calculation method that is also sufficiently accurate in its predictions of project viability. Despite its limited scope for accurate future predictions, it lends plenty of room to accuracy as its estimations set the precipices that can be taken for granted as good predictive outcomes.
- A business is an entity that deals in short terms and long terms. It possesses different goals for each period and has plans dedicated to meeting the criteria of these goals. However, it is a known fact that not only are we dead in the long term if the short term is neglected but the future as it extends out to a time and space without our existence, becomes more and more unpredictable. It is this unpredictability that can hurt returns and even turn fruitful assets in the short term into non-performing ones shortly. The scale and magnitude of risk are far greater in the long term than the short term as returns are susceptible to changes in governmental policy, trade cycles, and other variables that may deprive returns of their value. Therefore, this method indirectly favors short-term investment.
- Industry type also is an advantage that can be added to the list for this method. Investment in dynamic and prolific industries that carry high levels of obsolescence like software or the mobile phone development industry are great short-term opportunities for gaining hefty returns on investment. The success of these sectors of the economy has vindicated the value of investment done for the short term.
These were some of the many advantages that are pivotal to the popularization of this method among businesses all around the globe. However, even the Moon has its blemishes and there is no such thing as an only positive method. Every method carries its weaknesses, in its assumptions, procedures, or the key aspects of the subject under study that it drives past.
Some of the disadvantages of this method that turn into a less useful method than its discounted counterpart are:
- Money is a medium of exchange, a unit of account, a store of value, and a standard of deferred payments. Even though this method does take into account most of these characteristics of money, it fails to keep the temporality of money in its assumptions. Thus, it delivers a skewed view of money as a concept as initial cash flow is often favored over later cash flow.
- The method does not account for the payments or returns after the expiry of the PP. This period is not an accurate way of measuring returns to business investment as periods above ten years are considered far too risky yet many businesses may not extend returns until they reach a certain threshold of financial security after which their returns may skyrocket. Furthermore, it does not account for the excess returns gained after breaking even that are produced by the action of the investment multiplier.
- Financial calculations look like they are objective calculations and nothing more. Belief in such a distorted vision of finance is one of the major demerits of this method. It considers the objective metrics of finance and the indicators that cause a change in returns in the short and long. However, it fails to consider that environmental and social factors may lead to a rise in costs or reduce profitability and production. The benefits accruing in the short term due to natural exploitation and subsidies may not last for the long term.
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Q1. When is the PP method considered valuable?
It is a valuable method under most circumstances due to its simplicity, dexterity, and quickness. It is concerned with cash flows in the lack of appropriate cash flows for business sustenance; this method is invaluable to gaining insight into the value generated by certain projects in the short term.
Q4. What is the difference between a break-even point and a period of payback of the initial investment?
The period of payback of the investment is the period required to arrive at a break-even point after which the profit accrued to the business is considered profit or wealth if it’s released to the shareholders as dividends. The break-even point is the position where the returns on investment match the principal amount of investment. Hence, they are not the same.
Q3. Can payback period returns be negative?
Due to the increase in discounting over time due to the effect of compounding, positive payback returns may turn into negative ones after being discounted.
We hope you learned something of value through this article on investment returns, and methodologies to estimate the value of proposed business projects. The methodologies are differing and each of them possesses its strengths as well as numerous weaknesses. Hope learned how these methods fail and succeed in their operation to calculate the period for returns to match the initial investment. Thank you.