What is a payback?
A capital investment analysis method that measures the length of time it takes to recover, in net cash inflows, the cost of the initial investment.
Payback is a financial ratio that calculates the length of time required to recover the cost of an investment. It is one of the simplest and most widely used methods to assess the time it takes to repay an investment.
For example, suppose a company invests $100,000 in a new project and expects to generate cash inflows of $20,000 per year. Using the payback period, we can determine how many years it would take to recover the initial investment amount.
Assuming the company generates a uniform cash flow every year, the simple payback period would be:
Payback Period = Initial Investment / Annual Cash Inflows
In this case, Payback Period = $100,000 / $20,000 = 5 years
Thus, the payback period for this investment is five years, which means that it will take five years for the company to recoup the initial investment. The payback period is useful in evaluating projects with shorter expected life spans and less predictable cash flows. However, it doesn’t take into account the time value of money or the total return on investment, which can lead to inaccurate conclusions.
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