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Investment appraisal.

How long is it before our original investment in a project or asset has been paid back?

The faster the investment is paid back, the shorter the payback period, and the more attractive the opportunity, based on its payback period alone.

Payback analysis forecasts the cumulative net total of investment (one or more outflows - negative amounts) and return (inflows - positive amounts) in order to determine when that net total is zero.

This is the time when the initial investment has been fully recovered.

For example, a proposal requires an initial investment of $100m at Time 0 years, and will then pay out annual amounts of $10m, $20m, $30m, $40m, $50m and $60m at future Times 1 to 6 years respectively.

The cumulative net cash flow and payback period are calculated as follows:

Time 0: $(100)m.

Time 1: $(100)m + $10m = $(90)m.

Time 2: $(90)m + $20m = $(70)m.

Time 3: $(70)m + $30m = $(40)m.

Time 4: $(40)m + $40m = $0.

The initial investment has paid back after 4 years, so the payback period is 4 years.

Normally there is no attempt to adjust for money received in different time periods.

The underlying assumption is that the sooner you can 'get your money back' the better the project.

This is, of course, very simplistic, and it may lead to suboptimal decisions.

A slightly more sophisticated version of payback analysis is Discounted payback.

See also