Payback is one of the indicators reflecting the efficiency of the company's economic activity. It characterizes how competently and successfully the investment is used.
The essence of the payback period
In economic analysis, there are various approaches to determining the payback period. This indicator is used as part of a comparative analysis to determine the most profitable investment option. It should be noted that it is used only in complex analysis; it is not entirely correct to take the payback period as the main parameter of efficiency. Determining the payback period as a priority is only possible if the company is focused on a quick return on investment.
On the other hand, all other things being equal, preference is given to those projects that have the shortest payback period.
When implementing a project with borrowed funds, it is important that the payback period is shorter than the period for using external borrowings.
The indicator is a priority if the main thing for the investor is the fastest return on investment, for example, the choice of ways of financial recovery of bankrupt enterprises.
The payback period refers to the period during which capital costs are reimbursed. This is achieved through generating additional income (for example, when introducing more efficient equipment) or savings (for example, when introducing energy efficient production lines). If we are talking about a country, then compensation occurs due to an increase in national income.
In practice, the payback period is the time period during which the company's profit, provided by capital investments, equals the amount of investment. It can be different - month, year, etc. The main thing is that the payback period does not exceed the standard values. They differ depending on the specific project and industry focus. For example, for the modernization of equipment at an enterprise, the regulatory period is one, and for the construction of a road - another.
The payback period should be calculated taking into account the time lag between capital investments and the effect from them, as well as changes in prices and other factors (inflationary processes, growth in the cost of energy resources, etc.). According to this approach, the payback period is the time period after which, at the considered discount rate, the positive cash flow (discounted income) and negative (discounted investment) will be aligned.
Payback period calculation
In a simplified form, the payback period is calculated as the ratio of capital investments to profit from them. However, this approach does not take into account the time estimate of investment costs. This leads to an incorrect, underestimated payback period.
It is more correct to analyze the investment attractiveness of projects, taking into account inflationary processes, alternative investment options, the need to service debt capital.
Therefore, the payback period is equal to the sum of the number of years that preceded the payback year, as well as the ratio of the unrequited value at the beginning of the payback year to the cash flow during the payback year. The calculation algorithm is as follows:
- calculation of discounted cash flow based on the discount rate;
- calculation of the accumulated discounted cash flow as the sum of costs and revenues for the project - it is calculated up to the first positive value.
It remains only to substitute the indicated values into the formula.
