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Categories: business case
Payback period is an investment analysis technique and it’s personally one of my favourite tools to use for investment appraisal because in my view it’s the easiest to understand of the tools at my disposal.
Today I’m going to work through an example to show you what it looks like. But before we do that, let’s remind ourselves why we might want to use it at all.
Why Do An Investment Appraisal?
Investment appraisals are what goes into your business case to show why your project is financially viable. They are decision-making tools.
The investment appraisal also allows the decision makers to compare your project with others, which they’ll need to do as all the projects are competing for the same corporate funds. The figures from the investment appraisal, and the associated blurb in the business case, confirm why the project is worth the investment based on forecasted cost and time. It justifies the project based on the expected benefits.
So, investment appraisals matter because they help get your business case approved. Obviously, if the numbers don’t stack up then your project doesn’t get approved. Investment appraisal techniques help you show the cost and benefits of your project in a way that makes it easy to compare with others.
What Is Payback Period?
There’s a little video I made about payback period here, but in essence it’s this:
Payback period is the time taken to recoup the project investment.
Let’s take an example.
A project costs £1,000,000. The benefits are:
- Year 1: £500k
- Year 2: £300k
- Year 3: £200k
- Year 4: £200k
- Year 5: £200k
As you can see from the graph below, the project investment equals the benefits for the first three years, so the payback period is three years.
In other words, you’ll earn back the amount spent on the project through the project’s benefits once three years have passed. At that point you ‘break even’. Benefits from Year 4 are cash in the bank.
From a business case and project justification point of view, the shorter the payback period, the better.
Problems With Payback
So far, so straightforward.
The problems come when you try to be a bit more sophisticated.
For example, payback period doesn’t take into account discount rates (how much money will be worth in the future: is the £200k benefit in Year 4 really worth the same as £200k would be today?).
As with all investment appraisal techniques you can’t measure intangible benefits in this way. Payback is only good for working out the financial side of benefits: the monetary cost and the financial benefit gained.
That makes payback period a bit crude but as long as everyone is aware of the limitations, it can still be a useful tool to forecast when the project will break even and start to turn a profit.
There are other ways that you can put financial information into your business case: Net Present Value and Discounted Cash Flow are others.
What investment appraisal techniques do you use?
Posted on: September 02, 2016 10:49 AM |
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