paybackperiod

Payback period is the time required for the cumulative net cash inflows from a project to equal the initial investment. It is a simple capital budgeting metric commonly used to assess liquidity and risk. There are two main forms: the simple (undiscounted) payback period and the discounted payback period, which discounts cash flows to reflect the time value of money.

Calculation: For equal annual cash inflows, payback period = initial investment divided by annual cash inflow. For uneven cash flows, sum each year’s cash flow until the cumulative total covers the initial investment; the payback period is the number of full years plus a fraction of the next year. If the cumulative cash flows never reach the initial investment, the payback period is not achieved within the horizon.

Interpretation and limitations: The payback period indicates how quickly invested capital can be recovered, but it does not measure profitability and, in the undiscounted form, ignores the time value of money and cash flows after payback. The discounted form accounts for time value but still omits any consideration of post-payback benefits. Consequently, it is typically used alongside metrics such as net present value and internal rate of return.

Example: An initial investment of 100,000 with annual cash inflows of 30,000 yields 90,000 after three years; 10,000 remains, which is recovered in one-third of the next year, giving a payback period of about 3.33 years.