Payback period is a financial metric
that refers to the period of time required for the return on an investment
to repay the sum of the original investment. It corresponds to the
length of time required for cumulative incoming returns to equal the
cumulative costs of an investment, usually measured in years.
Formula
for payback period
If there are projected benefits at the start of the project
which exceed costs, then payback period is zero, corresponding to
the first time period. If costs reduce over time and benefits continue
to accrue, the payback period is the period at which the accrued benefits
equals or exceeds the accrued costs. If the accrued benefits never
equal or exceed the accrued costs, then the payback period is -1,
indicating that a payback condition is never met.
For example, a
USD1000 investment with USD500 returns every year would have a two-year
payback period. The investment with the shorter payback period is
considered the better investment because the investment costs are
recovered sooner and are available again for further use.
The payback period is the first period
in which the benefits exceed the costs for the project. For example,
if j time periods elapse before the sum of benefits exceed
the sum of costs, the payback period is j. To compute the payback
period, a discounting factor is also included in the calculation.
The formula is used for a standard investment analysis model, which
has a value stream, Revenue (R), and two cost streams, Development
Cost (D) and Maintenance Cost (M).