Glossary · UK
What is Payback Period?
The length of time it takes for an investment or business project to generate enough cash to recover its original cost.
Full Definition
The payback period is a simple capital budgeting measure showing how long it will take for an investment -- such as new equipment, a piece of machinery, or a business expansion project -- to generate enough net cash inflow to recover the amount originally spent on it. A shorter payback period is generally seen as lower risk, since the money is recovered and can be redeployed sooner, and it is particularly favoured by smaller businesses and cash-constrained organisations as a quick, easy-to-understand screening tool for comparing competing investment options, without needing detailed discounted cash flow modelling. Its main limitation is that it ignores everything that happens after the payback point is reached, and it does not account for the time value of money -- GBP 1 received in year one is treated the same as GBP 1 received in year five, even though money received sooner is generally worth more, because it can be reinvested or used to reduce debt earlier. Because of these limitations, payback period is usually best used alongside other appraisal methods such as Net Present Value or Return on Investment rather than as the sole basis for a significant investment decision, particularly for longer-term projects where cash flows well beyond the payback point matter a great deal to the overall return.
How Payback Period is calculated
Payback period = Initial investment cost / Annual cash inflow- Initial investment cost
- The upfront cost of the project or asset.
- Annual cash inflow
- The extra cash the investment generates each year (assuming even cash flows).
Worked example: A GBP 40,000 piece of equipment that generates GBP 10,000 of extra annual cash flow has a payback period of 40,000 / 10,000 = 4 years.