Payback Period
Candlefocus EditorThe payback period can be used to compare different investments that have the same initial cost. A shorter payback period is generally seen as a more attractive investment than a longer payback period; with a shorter payback period implying a quicker return, and more investment potential. Meanwhile, a longer payback period generally means a slower return on investment, and a larger risk associated with the investment.
Calculating a payback period is fairly simple and can be carried out using a few different methods. The first way involves taking the investment cost of the asset and dividing it by the expected future annual cash flow. This will give you an estimated number of years it will take to pay back the initial cost of the investment.
The second way of calculating the payback period is similar to the first but uses a discounted cash flow approach. This approach takes into account the time value of money by looking at the present value rather than the future value of the investment's cash flows. This method tries to account for the fact that money is worth more today than money you may receive in the future.
The downside of the payback period is that it fails to take into account any costs or benefits that may occur after the payback period. It is strictly a rough time-based calculation, which does not include any other costs or benefits that may arise from a particular investment. Also, if there are multiple cash flows which occur at different times, it becomes much more difficult to accurately calculate the payback period.
In conclusion, the payback period is an important metric to consider when evaluating an investment. It is a straightforward way to measure the speed of return on an investment and can help inform an investor’s decision-making process. It should be noted, however, that the payback period does not take into account the time value of money and may not accurately account for any other costs or benefits associated with a particular investment.