payback period method

A method of capital budgeting in which the time required before the projected cash inflows for a project equal the investment expenditure is calculated; this time is compared to a required payback period to determine whether or not the project should be considered for approval. If the projected cash inflows are constant annual sums, after an initial capital investment the following formula may be used:
payback (years) = initial capital investment/annual cash inflow.
Otherwise, the annual cash inflows are accumulated and the year determined when the cumulative inflows equal the investment expenditure. The method is sometimes seen as a measure of the risk involved in the project.
The two major weaknesses of the payback method are:
• the time value of money is not considered;
• the cash flows after the investment is recovered are not considered.
However, payback is a relatively simple technique for managers to use and for this reason it remains popular. Often managers use payback and discounted cash flow techniques at the same time, even though they are very different methods of capital budgeting (see discounted payback method).
example
A hospital is considering the purchase of a new X-ray machine for £50,000. The annual cash savings from the new machine are estimated at £20,000.
payback = initial capital investment/annual cash inflows = £50,000/£20,000 = 2.5
The hospital will therefore recover its investment in 2.5 years. On this basis, it is difficult to say whether the hospital should buy the new machine. Most managers would see a payback period of less than 3 years as good.

Accounting dictionary. 2014.

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