When deciding on investments in a project, potential investors evaluate a combination of factors. This is the situation in the investment and financial market, and the investor’s experience in a specific area, the geopolitical situation in the region, and much more. One of their important indicators is the payback period. It is the period during which net profit will take a positive value. In other words, it shows the time for which the initial investment will pay off. A reference point is either the actual start of operations or the time of initial investment. Of course, every investor is interested in making the payback period of the project as short as possible. However, this parameter should be considered in conjunction with indicators such as, for example, the level of risk. For projects with a high level of risk, the payback period should be shorter, because the investor risks not only his own, but also borrowed funds. It is especially important that this period be small if initially limited funds are allocated, for example, to the modernization of obsolete production.
Determining the estimated payback period, that is, reaching the breakeven point, is not a laborious process, and this is a great advantage of this method of assessing the investment attractiveness of a project. However, it does not take into account the distribution of invested funds and many other factors, which does not allow a high degree of accuracy to evaluate profitability. However, in the initial assessment of the attractiveness of several projects, they are often compared precisely by the payback period.
In the economy of the Soviet era, the term "payback period for capital investments" was used, that is, the period for which the effect of production costs is achieved. This effect can be profit, as well as cost reduction if a single enterprise is considered. We apply this term to both industry and the country as a whole, then the effect is understood as an increase in national income. The effectiveness of the project is determined on the basis of whether the normative payback period is observed or not.
How is the payback period of the analyzed project calculated? There are currently several approaches. The choice depends on whether the amount of cash receipts from the project is the same over the years, and also on whether the calculation of the changing cost of funds is taken into account.
1. The simplest case is when it is assumed that the proceeds from the implementation of the investment project will be the same for all coming years. Then the payback period (abbreviated PP, from the English Payback Period) is calculated using the simple formula PP = I / CF. Here I is the total investment, and CF is the average annual income.
2. A phased method of calculation is used for uneven cash receipts from the project. The calculation principle is the same, however, the total number of periods and receipts is separately calculated.
3. If you take into account the change in the value of money over the years of the project, then talk about a discounted payback period. Discounting is the calculation of the present value of funds that are expected to be received in the future. The calculation is made taking into account the discount rate, which is determined on the basis of the risk-free rate, followed by all risks. The discount rate can also be calculated on the basis of the internal rate of return, interest on borrowed capital, etc.
To summarize what has been said: the payback period is an important criterion that helps to quickly compare the investment attractiveness of several projects, but it cannot be a reliable indicator of the profitability and reliability of investments.