Investment Appraisal - Simple payback - 3.3.2

Investment Appraisal - The use of numerical techniques to predict the financial outcomes of potential capital investments.

Payback - The length of time (payback period) required to recover the cost of an investment in a project.

FORMULA  - PAYBACK

NET CASH FLOW IN YEAR THE INITIAL INVESTMENT IS REPAID / 12 MONTHS = £? REMAINING CASH TO BE PAID IN FINAL YEAR TO REACH THE REPAYMENT TOTAL / £?= DECIMAL = MONTHS

A BUSINESS WANTS THE LOWEST PAYBACK TIME IN ORDER TO BECOME PROFITABLE QUICKER.

Interpretarion of payback gives a prediction of when the investment will be paid back and more importantly the point at which it will start to  make a profit for the business. Businesses can use payback to consider a number of potential options and then choose the investment with the fastest payback. Alternatively, businesses may allow investment only if payback is within a maximum period of time, for example 24 months.

Advantages	Disadvantages
Simple and easy to use	Encourages short-term thinking about the investment
Easy to interpret	Ignores qualitative aspects of the decision, such as which best meets the needs of customers
Focuses on cash, which is important to the everyday success of the business	Ignores cash flow after payback has been completed and therefore cannot be used on its own to make a decision about the investment
Straightforward to compare competing investments for limited resources and the opportunity cost of each	The longer the payback period, the greater the degree of risk and uncertainty
	Doesn’t consider how the business is being funded, for example if via a bank loan, what will the impact be on gearing