Another tool for financial decision making
We’ve talked previously about using ROI to determine which projects to fund. This isn’t the only way to make those decisions, as Ski points out with the concept of flush. Payback period is the measure of how quickly an investment returns the invested amount, or the break-even point in the investment.
Using payback period
When we are managing a business or a project by cash-flow (versus income), we care very much about how quickly we get our money back. It is a reality that some companies (or project sponsors) choose the less-profitable investment if they get their money back faster. The most common reasons for this decision would be if a private company is strapped for cash, and does not want to use debt to finance operations. Public companies can also be faced with this situation, if they find that market valuations are predominantly driven by cash flow instead of profitability. A bootstrapped start-up company may also be forced to make short-term investment decisions based upon cash flow.
Companies faced with a high level of uncertainty for their investments will also find payback period analysis attractive. Since payback calculations will have the same inherent risk (and error) as expected value calculations, this presents a false sense of security. It does, however, provide a mechanism for controlling risk by favoring “get my money back sooner” projects over those with longer payback periods.
When using payback period to make investment decisions, companies will usually have a standard time period, such as two years or two quarters. Any project that has a payback period of less than the standard will be acceptable. Those projects that take longer to return the original investment than the standard period will not be acceptable.
Definition of payback period
From Philip Cooley’s Business Financial Management:
A popular procedure in practice that measures the time required to recapture through cash inflows a project’s net investment cash outflow. Payback ignores time value of money and post-payback cash flows. It measures the return of capital, not the return on capital.
Problems with payback period
Payback period analysis is not considered to be an ideal evaluation mechanism for three reasons.
- The time value of money (used in NPV calculations) is not considered. $100,000 three years from now is considered to be equivalent to $100,000 today.
- Cash flows beyond the payback period are ignored, thereby ignoring the ultimate ROI of the investment.
- The required rate of return (IRR) for the project is ignored. Less profitable projects will be favored if they return the initial investment more quickly than more profitable projects.
We suggest using payback period only when cash-strapped (with an aversion to debt-financing), or as a tie-breaker against apparently equivalent projects (based upon ROI).