Payback period in capital budgeting refers to the time required to recoup the funds expended in an investment, or to reach the break-even point.
Payback period is popular due to its ease of use despite the recognized limitations described below.
The term 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 as having a payback period of a certain number of years or operating hours, assuming certain costs.
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not 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 weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.
[4] It can also be calculated using the formula: Where ny= The number of years after the initial investment at which the last negative value of cumulative cash flow occurs.
This formula ignores values that arise after the payback period has been reached.
Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime.
Payback period doesn't take into consideration the time value of money and therefore may not present the true picture when it comes to evaluating cash flows of a project.
Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period.