Payback Period

Payback period refers to the length of time needed to get back the original cost of an investment . It is probably the simplest method of looking at a project or idea . With a very simple calculation formula that is : Payback Period Cost of Investment /Annual Cash Inflows , it is easy to comprehend even by those who are not experienced in the field of finance , thus , it is widely used in capital budgeting . As an example consider having an investment amounting to 300 ,000 and the projected annual returns is 50 ,000 . Payback period

will be computed as follows 300 ,000 50 ,000 6 . This means that only after six years can you recuperate your total investment . The rule of the thumb is , all other things being equal , the shorter the payback period , the better the investment . This method , simple as it may be , has also weaknesses and limitations . The two main problems associated with this scheme are the following

It does not measure profitability or the total incomes since it already ignores the benefits that occur after the payback period

It does not consider the time value of money

Going back to the example given earlier , after six years , you know that you have already regained the capital you have invested , but how much have you really earned ? What the payback period offers is just the assurance that you will get back what you have originally given , the interest , if there is , is not included in the computation . If you...