Payback Period

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Recovering the costs of investments. Explanation of Payback Period (PP).

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What is the Payback Period? Description

The Payback Period is perhaps the simplest method of looking at one or more investment projects or ideas. The Payback Period method focuses on recovering the cost of investments. The Payback Period represents the amount of time that it takes for a capital budgeting project to recover its initial cost.
 

Calculation of Payback Period. Formula

 Payback Period recovering the costs of investmentsCalculating the Payback Period can be done in the following way:


           The Costs of Project / Investment

PP =   --------------------------------------------------

           Annual Cash Inflows


The Payback Period concept holds that all other things being equal, the better investment is the one with the shorter payback period.


Example of Payback Period calculation


For example, take a project costing a total of $200,000. The expected returns of the project amount to $40,000 annually. The Payback Period would be $200,000 : $40,000 = 5 years.
 

Benefits of Payback Period

The Payback Period certainly has the virtue of being easy to compute and easy to understand. But that simplicity carries weaknesses with it.


Limitations of the Payback Period

There are at least two major problems associated with the Payback Period model:

1) PP ignores any benefits that occur after the Payback Period. It does not measure total incomes.
2) PP ignores the time value of money.

Because of these two reasons, more professional methods of Capital budgeting are advisable.


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