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Payback period
Payback period in business and economics refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. It intuitively measures how long something takes to "pay for itself." Shorter payback periods are obviously preferable to longer payback periods (all else being equal). Payback period is widely used due to its ease of use despite recognized limitations, described below.
The expression is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described of having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing," payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not properly account for the time value of money, risk, financing or other important considerations such as the opportunity cost. Whilst the time value of money can be rectified by applying a weight average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment. There is no formula to calculate the payback period, excepting the simple and non-realistic case of the initial cash outlay and further constant cash inflows or constant growing cash inflows. To calculate the payback period an algorithm is needed. It is easily applied in spreadsheets. The typical algorithm reduces to the calculation of cumulative cash flow and the moment in which it turns to positive from negative.
Additional complexity arises when the cash flow changes sign several times, that is it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. Firstly, the sum of all of the cash flows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback period is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.
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