The role of payback in financial decision-making

Payback: The Role of the Concept of Payback in Risk Management

Good investment strategies are always tempered with a heavy dose of risk management. In accounting and finance, 'payback' is defined as the length of time it is required to recover the initial amount of the capital investment: in other words, how long will it take to earn back the cost of the investment. Payback is a simple, relatively straightforward and informal method of determining the likelihood and time frame in which an investment will 'pay off' and enables a firm to decide if the investment risk is worth undertaking. "If the cash inflows occur at a uniform rate, it is the ratio of the amount of initial investment over expected annual cash inflows" (Payback period, 2010, Accounting Dictionary). The time value of money or the depreciating value of currency is not part of the calculation. "For example, assume projected annual cash inflows are expected to be $6,000 a year for five years from an investment of $18,000. The payback period on this proposal is three years, which is calculated as follows: Payback period = $18,000/$6,000 = 3 years" (Payback period, 2010, Accounting Dictionary). Of course, it is very rare that annual cash inflows will be perfectly stable and steady, but even when they are not is still possible to calculate the investment return using payback strategies: "assume instead that the cash inflows are $4,000 in the first year, $5,000 in the second year, $6,000 in the third year, $6,000 in the fourth year, and $8,000 in the fifth year. The payback period would be 3.5 years. In three years, all but $3,000 has been recovered. It takes one-half year ($3,000 / $6,000) to recover the balance" (Payback period, 2010, Accounting Dictionary).

Ideally, when computing risk, a shorter payback period is superior. A short return period means funds are more quickly rendered liquid and can be reinvested, although the depreciating value of money is not involved in the calculation. On one hand, advantages of the payback method of calculation are "(1) it is simple to compute and easy to understand and (2) it handles investment risk effectively" (Payback period, 2010, Accounting Dictionary). Some non-traditional payback methods do take into consideration the time value of money, although it makes the calculations considerably more complex and somewhat undercuts the simplicity advantage. But the disadvantages of the method include "(1) it does not recognize the time value of money and (2) it ignores profitability of an investment" (Payback period, 2010, Accounting Dictionary). Thus, payback computation does not take into consideration that a technological investment can cause other aspects of the firm to improve in speed and meeting customer needs, nor does it take into consideration the opportunity cost of doing nothing, and falling behind one's competitors. A firm that does not update its software, for example, could lose valuable opportunities, prospects, and fail to ensure its workplace remained competitive.

Additionally, although there is no formal rule, as a general principle, if a project 'pays back' in less than a year, it is considered essential, while if it takes over three years, its attractiveness should be radically reconsidered (Payback period, 2010, Q-Finance). Usually, companies determine a standard payback time period, for projects "such as two years or two quarters" when screening potential investments (Sehlhorst 2006). One justification for such hard and fast rules is that the longer the investment takes to 'pay back' given the expected firm profits, the more likely the capital expended upon the investment could have been better used on something else, including more innovative and potentially less expensive technology and other market opportunities that could have 'paid back' more quickly. And "the payback period relies on the assessment of a company's earnings potential. It is harder to predict such potential further into the future, and subsequently there is a greater risk that those returns will not occur" (PEG payback, 2010, Answers.com). Thus short-term return investment predictions are more likely to be accurate. Few economists, for example, predicted the extent of the recent credit crisis and market meltdown. Payback duration can also be evaluated in terms of the collective body of investments made by a firm. A large amount of investments that can only 'pay back' over the long-term could threaten a firm's financial health, if market conditions rapidly change. This level of risk is especially true for a small, young organization that has a statistically higher probability of failure during its first years.