The Simplest Question in Capital Budgeting
The payback period asks only one thing: how long until the money comes back? Where cash flows are even, it is a division:
Payback period = Initial investment / Annual cash flow
Where they are uneven, you accumulate year by year and interpolate within the year that crosses the line. A $50,000 investment returning $12,000, $15,000, $18,000 and $20,000 crosses during year four, at 3.25 years.
Simple Against Discounted
Simple payback treats a dollar in year four as equal to a dollar today, which is wrong. Discounted payback applies a discount rate first, and always takes longer:
| Year | Cash flow | Cumulative | Discounted at 8% | Cumulative discounted |
|---|---|---|---|---|
| 1 | $12,000 | −$38,000 | $11,111 | −$38,889 |
| 2 | $15,000 | −$23,000 | $12,860 | −$26,029 |
| 3 | $18,000 | −$5,000 | $14,289 | −$11,740 |
| 4 | $20,000 | $15,000 | $14,700 | $2,960 |
| 5 | $22,000 | $37,000 | $14,972 | $17,932 |
Simple payback: 3.25 years. Discounted payback: 3.80 years. The half-year difference is the cost of waiting, and it grows with both the rate and the length of the project.
What It Ignores
Payback is popular because it is intuitive, and dangerous for the same reason. It says nothing about what happens after the payback point. A project repaying in three years and then stopping scores better than one repaying in four and then generating cash for a decade. Used alone, it systematically favours short, small projects over valuable long ones.
This is why it belongs alongside NPV and IRR rather than instead of them: payback measures risk exposure and liquidity, not value creation.
When It Is the Right Tool
- Liquidity is tight. A business that must recover cash quickly cares more about timing than total return.
- Technology risk is high. Where obsolescence is likely within five years, cash returned early is cash actually received.
- Political or country risk. Long-dated cash flows in unstable environments may never arrive.
- Screening. As a first filter before the more expensive NPV analysis.
Typical corporate hurdles are two to four years for equipment and under a year for energy efficiency projects.
Frequently Asked Questions
What is a good payback period?
It depends on the asset's life. Under three years is generally considered strong for equipment; solar installations are commonly justified at seven to ten because the asset lasts twenty-five.
Should I use simple or discounted payback?
Discounted, whenever the period exceeds two years. Below that the difference is small enough not to change decisions.
Can the payback period be longer than the project?
Yes, and that is a clear rejection: the investment never recovers its cost.