The Payback Method

The payback method is quite a simple concept. The majority of business projects (or even entire business plans for an organization) will require capital. When investing capital into a project, it will take a certain amount of time before the profits from the endeavor offset the capital requirements. Of course, if the project will never make enough profit to cover the start up costs, it is not an investment to pursue. In the simplest sense, the project with the shortest payback period is most likely the best of possible investments (lowest risk at any rate).

Time Value

Time is a commodity with cost from a financial point of view. For example, a project that costs $100,000 and pays back within 6 years is not as valuable as a project that costs $100,000 which pays back in 5years. Having the money sooner means more potential investment (and thus less opportunity cost). The shorter time scale project also would appear to have a higher profit rate in this situation, making it better for that reason as well.

If a payback method does not take into account the time value of money, the real net present value (NPV) of a given project is not being calculated. This is a significant strategic omission, particularly relevant in longer term initiatives. As a result, all corporate financial assessments should discount payback to weigh in the opportunity costs of capital being locked up in the project.

Discounted Payback

One way to do this is to discount projected cash flows into present dollars based upon the cost of capital. So a simple example of a payback period without time value of money (without discounted payback) would be as follows:

A project costs $10,000. It will return $2,000 each year in profit (after all expenses and taxes). This means that it'll take a total of 5 years without a time value of money discount being applied. However, applying time value of money is a fairly simple process, and can be accomplished utilizing the discounted cash flow analysis equation:

${\displaystyle DCF={\frac {CF_{1}}{(1+r)^{1}}}+{\frac {CF_{2}}{(1+r)^{2}}}+\dotsb +{\frac {CF_{n}}{(1+r)^{n}}}}$

For the sake of simplicity, let's assume the cost of capital is 10% (as your one and only investor can turn 10% on this money elsewhere and it is their required rate of return). If this is the case, each cash flow would have to be $2,638 to break even within 5 years. At your expected $2,000 each year, it will take over 7 years for full pay back.

As you can see, discounting the payback period can have enormous impacts on profitability. Understanding and accounting for the time value of money is an important aspect of strategic thinking.