How does the payback method in investment analysis work? How to calculate the payback period? Find out all about the beauty of the payback method, as well as its shortcomings.

The payback method asks a very simple central question: How many years does it take to recover the initial investment?

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0:00 Payback method explained
0:23 Payback period calculation
1:05 Payback method project comparison
2:11 Payback method shortcomings

Let’s calculate the payback period for project A. In year 0 (today), we have a cash outflow of $1000. The brackets around the number indicate that it is a negative, a cash outflow. Over the course of the project, we have $1600 worth of benefits (cash inflows) in total, split evenly over 4 years of $400 each. It’s fairly easy to calculate that the payback period is 2.5 years: $400 of benefits in year 1, plus $400 of benefits in year 2, plus six months’ worth of benefits in year 3 making up the final $200, at which point the total investment equals the total benefits.

What if we have multiple projects in our company that we want to force rank? We only have $1000 of investment money to spend, which project is (financially speaking) the most attractive? In total, for the full 4 years combined, each of the three projects has $1600 worth of cumulative benefits, but the timing of these benefits varies. Applying the payback method can help! We already calculated the payback period for project A at 2.5 years. Project B has a payback period of 1.8 years: $600 in year 1, and (assuming we have benefits evenly spread over the year) $400 out of the year 2 benefits. Project C has a payback of 3 years: $200 in year 1, $300 in year 2, $500 in year 3. The payback method does a good job here, it recognizes that time is money; earlier benefits are more valuable than later benefits. Project B is the most attractive.

However, the payback method, while nice and simple, has a crucial blind spot. It answers the question “How many years does it take to recover the initial investment?” Nothing more, nothing less. So if project A has an investment of $1000 and 4 years of $400 benefits per year, and project D has an investment of $1000 with 5 years of $400 benefits per year, the payback method tells you that both projects are equally attractive at a payback period of 2.5 years. This is where more sophisticated methods like Net Present Value or Internal Rate of Return have to come in to provide a calculation. Or just plain common sense, as any entrepreneur with skin in the game would intuitively and correctly choose project D over project A, without having heard of any of the more fancy terms.

Philip de Vroe (The Finance Storyteller) aims to make strategy, finance and leadership enjoyable and easier to understand. Learn the business vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better stock market investment decisions. Philip delivers training in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!