The payback for an investment is the number of periods management must wait before the accumulated positive cash flows from the investment exceed the initial cost of the investment project plus any negative operating cash flows. Investments are considered acceptable when the payback period is less than some predetermined time period, for example 3 years. Here is the computation:
Beginning investment: |
$100,000 |
Cash flow year 1: |
−$15,000 (with the beginning investment, $115,000 still left to recover) |
Cash flow year 2: |
$50,000 ($65,000 still left to recover) |
Cash flow year 3: |
$60,000 ($5,000 only left to recover) |
Cash flow year 4: |
$60,000 |
Cash flow year 5: |
$60,000 |
In this example, the payback occurs at about 3 years and 1 month. Many people do not consider payback to be a discounted cash flow technique because it does not take into account the time value of money. This is not entirely true. A short payback period, say, for example, 2 years, reflects the importance of dollars received in the short term and thus the time value of money. 1 The payback approach does not take into account cash flows that are outside of the payback threshold and they do not take into account the magnitude of the cash flows. Amazon is now a viable business but early investors did not consider the payback to be an important tool for deciding whether to invest in Amazon. This is a normal situation for many start-ups where positive cash flows do not occur until many years in the future. Discounted cash flow approaches incorporate the importance of distant cash flows and the magnitude of the cash flows.
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