Payback period

Definition

The payback period is the time it takes for an investment to generate cash flows sufficient to recover its initial cost. It is a simple measure used to evaluate the risk associated with an investment.

5 Must Know Facts For Your Next Test

1. The payback period does not take into account the time value of money.
2. It is often used as a preliminary screening tool for investments.
3. Shorter payback periods are generally preferred as they indicate quicker recovery of investment costs.
4. The method ignores any benefits that occur after the payback period has been reached.
5. It is particularly useful for evaluating projects with high uncertainty or short lifespans.

Review Questions

• What limitation does the payback period have regarding the time value of money?
• Why might companies prefer investments with shorter payback periods?
• How does the payback period method treat cash inflows occurring after the initial investment is recovered?

Related terms

Net Present Value (NPV): A financial metric that calculates the present value of all cash flows associated with an investment, both incoming and outgoing.

Internal Rate of Return (IRR): The discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

Discounted Payback Period: An advanced version of the payback period that accounts for the time value of money by discounting future cash flows.