Explanation of payback period, discounted payback period, cutoff period, and payback reciprocal method with accounting examples.

1. What is payback period?

Payback period (in capital budgeting) is the number of years necessary to recover the original investment.

In other words, as its name suggests, the payback period represents the time it takes the investment to be paid back. The payback period method is commonly used by companies to evaluate investments: the goal is to choose a project that will recover the investment in the shortest time (i.e., with the shortest payback period). Investments taking less time to be recovered are considered as less risky. As the result, sometimes companies might establish a limit on the payback period beyond which no investment is done (i.e., cutoff period).

Cutoff period is the pre-determined (desired) length of time for an investment to be recovered.

When the payback period is shorter than the cutoff period, the investment can be accepted. When the payback period is longer than the cutoff period, the investment cannot be accepted in accordance with the payback period method.

Though the payback period method is quite useful in assessing a project’s risk and liquidity, other financial capital budgeting methods -- such as present value and rate of return – should be also used to evaluate investment alternatives. An investment should not be based solely on the payback period acceptance.

2. Advantages and disadvantages of the payback period method

Advantages of the payback period method:

• Easy to use
• Can be used with other capital budgeting techniques
• Considers the risk of investment

Disadvantages of the payback period method:

• Does not consider the time value of money concept: does not discount cash inflows
• Does not consider cash inflows after the original investment is recovered
• Does not measure the profitability of a project
• Does not effectively evaluate projects with small cash inflows in the beginning and large cash inflows later on

To address some of the above-listed disadvantages, a company should determine an appropriate cutoff period and discount cash flows before calculating the payback period.

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