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Definition: Payback Period
The payback period is a tool of analysis used in Capital Budgeting to decide whether a particular project should be taken or not or for choosing amongst two or more project opportunities. It is defined as the time required to recover the investment made/ cost incurred in a project. Accordingly, a project with a shorter payback period is preferred over that with a longer one. Mathematically, for a project with even cash inflows, it can be expressed as
Payback Period = Initial investment/ Annual Cash Inflows
In case of uneven cash inflows, payback period can be calculated as
Payback Period= n1+ CCFn1/CFn1+1
Where, n1 is the no of years at which the last negative cumulative cash flow occurs;
CCFn1 is the absolute value of cumulative cash flow at the end of n1 years; CFn1+1 is the total cash flow during the period following n1 years
Owing to its simplicity and ease of use, payback period is widely used in capital budgeting decision making. However, it has its limitations as it does not consider time value of money, risk, return and opportunity cost.
Example: The payback period for a project requiring an investment of $120m and generating an even cash flow of $25m for 10 years is 120/25= 4.8 years.