Evaluating capital investment options requires calculating the potential compensation and the risk of each project. The pay back method of investment appraisal establishes the amount of time the investment must be held before cash receipts equal the initial investment total. Analyzing investments in this manner incorporates the short-term income potential of the project and the rate of return, but does not account for long-term earnings potential or the time value of money. Investments with shorter pay back windows are favored over longer-term selections.
Establishing a payback period assigns a risk value to investments. Opportunities that feature a rapid return on invested capital are less risky than projects with a long-term payback period. Companies or investors can balance the expected return with the amount of time the capital will be unavailable for other investments.
Calculating the payback period of investments establishes a tangible financial risk total for each project. The numerical value offers an objective comparison between various project options. As long as the same calculation method is used for each pay back calculation, projects can be ranked by risk and time commitment.
Investments that pay back quickly are easier to flip for other opportunities. These investments can be evaluated after the initial capital repayment to determine if the return is higher, lower or consistent with the initial investment appraisal. Investments that offer a higher rate of return may be held to reap additional profit, while investments with lower returns can be liquidated and reinvested into other financial vehicles. Reinvestment potential is particularly important for investments in technology or machines that need updating frequently.
Establishing a payback period is easier than other capital budgeting calculation methods such as internal rate of return (IRR) or net present value (NPV). The pay back calculation divides the initial project cost by the yearly income amounts. Opting for a payback analysis makes decisions easier as the method is easy to explain to business partners or other investors.
Selecting capital investments based on pay back speed prevents cash flow issues. Ensuring sufficient cash reserves are available can avert payroll or expense payment shortfalls. Recovered cash can be used for operating expenses, maintenance, employee expansion or other investments.
Selecting investments based on payback period allows investors to balance cash flow with their financial needs. Investments can be staggered to return a consistent cash flow stream or to pay back lump sums at specific periods of higher financial requirements.