The payback period is the number of years required to recover funds invested in a project. Normally a short payback period is much preferred to along payback period. Not only is the return crystallised sooner, risk to the business is reduced.
However, long-payback projects may still be worthwhile, for example in gaining a strategic presence in a new or growing market.
The choice of project based purely on payback period is therefore arbitrary.
In assessing payback on larger or longer-term projects, it is essential to consider the time value of money. The discounted payback period therefore needs to be evaluated. This process calculates future returns on the investment in today’s money, against which the initial outlay is compared to compute the number of years taken to recover the initial outlay.
Discounted payback period may not always be appropriate or necessary, such as projects with a small initial outlay.
In addition, payback only computes the time taken to return the initial outlay. It does not evaluate the total returns or cash flows over the life of a project (beyond the payback period). For this reason, the payback period should not be used in isolation in project evaluation – other tools such as internal rate of return or net present value should be used.
Meridian can assist in project payback exercises by:
- Calculating the payback and discounted payback periods
- Evaluating tax implications for the payback calculations
- Running other project appraisal calculations, such as net present value and internal rate of return