Many pay-back. Sometimes called payout or payoff, period of an investment represents the number of years required to return the initial cash investment by savings before depreciation but after the payment of taxes. It is the ratio of the initial fixed investment over the annual cash inflows for the recovery period (Van Home), In other words, pay back method attempts to measure the period of time it takes for the original cost of a project to be recovered from the additional earnings of a project itself, Lower the period of pay back, better is the project.
In an investment of $25,000 is expected to earn or save $10,000 cash proceeds for the first three years, it will have a payback period of
(Initial Investment $25,000)
(Earning/Saving per year $10,000)
If the annual cash inflows are not equal the calculations become a little more complicated. Suppose that, in the above example the annual cash inflows are that, in the above example the annual cash inflows are $13,000 in the first year. $10,000 in the second and $8,000 in the third year. In the first two years, $23,000 of the original investment will be recovered. Followed by $8,000 in the third year. With an initial cash investment of $8,000 in the third year. With an initial cash investment of $ 25,000 the pay back period is : 2 years + $2,000 / 8,000 = 2 years.
Pay back is very simple and most widely used decision model for capital budgeting and certainly is an important men over the criterion of urgency, furthermore, it is handly device (i) where precision in estimates of profitability is not crucial and preliminary screening of a number of proposals is necessary (ii) where a weak cash and credit position of a firm must place a premium on quick returns of funds; and (iii) where the proposed project is extremely risk and returns beyond three or four years are too uncertain. The short term approach involve in pay back method reduces the possibility of less through obsolesouce, etc.
Essentially, pay back is measure of the time it will take to recoup in the form of cash from operations only the original rupees invested. The pay back method may often yield clues to profitability, because, given the pay back period, the greater the useful life of the asset, the greater the profitability, However, this method should not be used blindly, as the payback does not measure profitability. The major shortcoming of the pay back method is that it fails to consider cash flows after the pay back period. Thus, it may led to wrong conclusions where projects with long gestation period are involved. Moreover; an investment’s main objective is profitability, not recapturing the original outlay alone.