Payback Analysis

February 29, 2012

The payback analysis method is the simplest financial method to comprehend. Payback analysis refers to the period of time required for an investment to payback the original investment. The primitive formula for calculating Payback Analysis is the cost of the project divided by annual cash inflows. The result is referred to as the “payback period”. The payback analysis considers only these two things: cost and income. The payback period is found when the total cumulative income exceeds the total project outcomes. If there a project has varying outcomes then the method is modified to summate all of the outcomes and this number is used. Most companies want to invest in projects and opportunities that quickly pay for themselves. Payback analysis is usually used to compare multiple projects to help determine the best project to choose for implementation. Using this method the project with the smallest payback period is the best investment. Drilling to the project to most quickly repay itself lessens the likelihood that market conditions, the economy, interest rates and other variables will affect the project. Because it allows for an investment to be recouped on a shorter period allowing this money to be reinvested in other projects. Payback Analysis is usually measured in years. However, it is often used with respect to energy efficiency technologies, maintenance, upgrades or other changes. For example if this method is applied to light bulbs the period might be operating hours. In this case the return on investment might be considered as reduced operating costs.

An example of calculating a payback analysis could be the case of a widget which costs $250,000 to build and is expected to generate $50,000 a year. The payback period would be calculate to 5 years. Compare that to a second project with a cost of $300,000 and generating $100,000 a year. This payback period would be calculated to be 3 years. So the $300,000 project, while having more initial investment, would be the best project to undertake.

The payback analysis method has two serious flaws. The first flaw is that it ignores any benefits after the payback period. For example if first project above, for $250,000, had a yearly return of $1,000,000 and the second project above, for $300,000, had a yearly return of $100,000 the risk of two extra project years might be offset by the difference in reward. However, the payback analysis method does not take this into consideration and could not help to make this decision. For this reason it is generally suggested that this method only be used to compare similar investments.

The second flaw that this method has is that it doesn’t take into account the time value of money. The time value of money is stated as a dollar received today is worth more than a dollar received tomorrow. The reason for this is generally interest. When interest is owed then the payback period is actually elongated. A company could sell grants which would cause them to incur the effect of interest up front. Or it could be the case could be a case where a company has to borrow money to complete the project thus incurring the effect of interest during the repayment period. This interest is not considered in the payback analysis method even though paying it back will cause the payback period to be longer.

Because of these two issues it is recommended that the payback analysis method not be used in isolation. Economist will generally prefer to use “net present value” method or the “internal rate of return” method. It is also recommended that if this method is used then it be used in conjunction with other methods to overcome it’s built in limitations.

References

http://en.wikipedia.org/wiki/Payback_period

http://www.investopedia.com/terms/p/paybackperiod.asp

http://www2.ds.psu.edu/AcademicAffairs/Classes/IST260W/topic0D/topic_0119_04.html

http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_6530

http://www.toolkit.com/pops.aspx?pageID=P98_06_6510_01

http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_6510

Submitted by Jason Wergin

Advertisements

3 Responses to “Payback Analysis”

  1. Buck Huffman said

    The home energy industry uses these kinds of statistics all the time. Say when you’re pricing the cost of solar panels there’s usually a 10-15 year pay back period. What the doesn’t take into account is the TVM or the environmental impact that a consumer will be willing to pay for. The thought being I may save money over the long haul but I’m making an impact immediately that I value and am willing to pay a premium.

  2. Robert Hanson said

    echoing Buck, when looking to do a refi on a house..how long will it take me to get my processing fees and closing costs back by saving the $200/month on my mortgage, but it cost me $6000 to close

  3. simsjon said

    I think you need to look at more than one analysis when investing in something. Jason has an excellent example of just such a situation. It is best to weigh all of your options.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: