In this article, we're going to talk about the payback method which is a means of evaluating investment opportunities and whether or not to accept a project. So the first step with the payback method is we're going to calculate the payback period and what that means is we're calculating for a given investment how long it's going to take to recoup our investment.
If we invest $100,000 how long is it going to take for this investment to pay us that $100,000 back and then once we know what this payback period is how quickly the project will pay for itself then we can move to step two.
Step two is we are going to accept the project if that payback period is for a shorter length of time then whatever happens to be our required timeframe for our firm. So let's say for example that we require at our firm that all investments are paid back within 8 years and then we calculate for an investment that the payback period is actually going to be10 years it'll take 10 years before we get our money back on this investment. Then we would reject the project because the payback period is actually longer than the required timeframe. As for our firm, it's 8 years. The required time frame is up to your firm it's up to your CEO or your manager so this is going to vary on a firm-by-firm basis.
So let's jump into an example it'll make it a little easier for you to understand let's say that
You have a company that gives hot air balloon tours and let's say that you're thinking about buying an additional balloon you're saying, "Hey you know what I actually could get another balloon and then I'd be able to give more tours and make more money" so then you say well how much would that cost buy an additional balloon? I'm not talking about replacing the balloon you already have, I'm saying buy an additional one, one more, so let's say that was $300,000. So you can think of this $300,000 as an investment you're making an investment and you are expecting by investing this $300,000 to get an increase in sales. I want to expect to be able to get more money from now having an extra balloon.
So I want to know how quickly am I going to get my $300,000 back. First, we need to know what kind of sales increase do we expect in this case let's say we asked me $75,0000 a year now you could say let's say for the next 10 years. So for the next 10 years, you're going to get $75,000 a year increased sales because of buying this balloon for $300,000 and so for your company you say, "You know what I don't want to make an investment unless it's going to pay for itself within 5 years, if it's not going to pay for itself within 5 years I don't think it's a good investment, I don't want to do it."
So let's come map out the cash flows here and then make it a little bit easier for you to understand
So you've got time zero you're putting in negative $300,000 and I'm going to be getting this string here of 75,000 and this is actually going to go for 10 years this is going to be 10 times that it's going to actually go beyond this year 5 but we need to know within this time frame between years times zero which is just the beginning and year 5 will we have collected $300,000? will we have earned an extra $300,000 in sales to at least break even to get that $300,000 back?
Right now you might say "Well we're going to do this for 10 years so just take 10 times 75,000 that's 750 grand that's more than 300,000 right? So that's not how it works forget what happens after year 5. We just want to know before year 5.
So what we can do is let's just take the cost of the investment which is going to be $300,000 that's the cost of the balloon now we take that and we divide it by the incremental sales that we're experiencing each year so our annual increase in sales is $75,000 so we divide 300,000 by 75,000 and that is going to give us 4.
So what does that mean? That means it will take 4 years to recoup this investment. So think about it we put up 300,000 and we're saying that we're going to get an extra 75 grand a year and after 4 years the investment will have paid itself back. So let's take that 75,000 and multiply it by 4. What does that give us that gives us 300,000, what is 300,000? That's the exact amount that we invested in. Basically, we're saying look if we're going to get an extra 75000 a year it will take 4 years.
So at this point in time, we have already paid back our investment we've earned the money back now we say "well does that meet the specified time frame"? We have said that the payback period is less than the required time frame, while the quired time frame, in this case, is 5 years but we've paid it back here at end of year 4.
So what does that mean? That means that we're going to accept this project because the payback period is 4 years which is less than our required time frame to pay back our investments which were 5 years. So this is 4 years is less than the 5 that's required so we accept.
Now there are some important caveats with this payback rule:
Now it's very simple to use and that's why a lot of firms will use this payback method but it doesn't give any account to the time value of money. If we've gone through net present value and things there time value of money is a very important concept in finance. So $75,000 that's four years from now that's not worth the same as $75,000 today.
Now if you don't understand why we've our article on time value of money you can check out but it is just sufficient to say that the payback method just completely ignores that it ignores time value of money and it also ignores the cash flow after the payback period.
So in this case in our example we said that we're going to gain this extra 75,000 a year for 10 years well what if that we're evaluating a different project that had everything else the same except that it was 30 years. Now if we were to do the payback method for each one we would come out with accepting in each case now you might say "well accept each project," but what if we only had 300,000 dollars to invest? Then we're saying well look now we've got this mutually exclusive investment opportunity we can only take one of the two and if the payback would say "look they both payback within 4 years accept both." So it really doesn't take into consideration the fact that cash payments may be taking place after this time frame and we're not even thinking about that we're just thinking if this thing paid back and how quickly.
So another thing about payback that really is a drawback to it is that it's just completely arbitrary when we think about this payback period. For example, we say "well we want investments to be paid back within 5 years" well why 5 years? why not 6 years? why not five and a half years? why not 4 years? and we're really not thinking about any of these things.
So these are very important topics. So you might be wondering why do people even use payback at all? It seems like we should really be using net present value as net present value is the optimum or the optimal decision rule when we decide whether or not we want to accept a project you want to be thinking about NPV and sure you can have an internal rate of return as important metric too and you can use that in many instances but NPV is where the buck stops in terms of investing and deciding whether or not to do investment.
So this payback period it's got all these problems but people really like its simplicity and so it's not just that people might be lazy and don't feel like finding NPV in some cases you might have something where it's kind of like a trivial investment or a small investment and it's not something where you're really going to go and calculate out discount rate is and all these different things.
