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