Payback period or payout time is nothing but the minimum length of period theoretically needed to recover the original invested capital in the form of cash to perform a task or certain project which is based on the total income excluding all costs except depreciation. It would take a longer time to recover the money, if the original invested money is higher.
It is one of the mathematical methods of evaluating profitability. Payback period execution method has an advantage of putting the evaluation of profitability analysis of all the alternative investments made on an equal basis; therefore it permits a wide comparison of risk factors. Generally, this method includes the original capital investment or the capital cost invested to begin a project which means only the original, the average depreciation cost in years, the average profit in years, fixed capital investment and the rate of interest.
There are two methods in the execution of payback period. One method is, the determination of payback time excluding the rate of interest while the other method is with the inclusion of the rate of interest. The following methods are:
- Payback period in years excluding the annual interest can be calculated as the ratio of fixed capital investment which is depreciable to the sum of the average annual cash flow in years including the average depreciation in years.
There is another way to determine payback period which considers time value of money as an important factor and it is designated as “Payout time including interest”. An appropriate rate of interest is chosen in this method. The annual cash flow of a certain project during an estimated service life are discounted at the desired rate of interest to permit the determination of the average annual profit, in addition to depreciation which reflects time value of money.
- Similarly payback period in years including the annual interest can be given as the ratio of fixed capital investment which is depreciable in addition to the interest on the total capital investment during an estimated service life to the sum of the average annual cash flow or annual profit in years and the average depreciation in years.
Therefore, from the above two methods of calculating the payback period, the later one is more advantageous than the payback period calculation without interest charges. As the payback period determination including interest increases the payout time while performing certain project, more profits can be gained during an early stage of the given service life.
Payback period calculation method is also designated as “The recovery of capital with minimum profit”.
