Payback Period and Discounted Payback: Quick Project Assessment Methods

Introduction: The Simplest Question in Investment

“How long will it take to get my money back?”

This is often the first question an entrepreneur asks before making any investment. A ₹50 lakh investment that returns the capital in 2 years feels very different from one that takes 10 years.

The payback period method, while simple, answers this fundamental question. Despite its limitations, it remains one of the most widely used capital budgeting techniques—especially in India’s risk-aware business culture.

What is Payback Period?

Definition

Payback period is the time required to recover the initial investment from a project’s cash flows.

Simple Formula (Even Cash Flows)

$$Payback\ Period = \frac{Initial\ Investment}{Annual\ Cash\ Flow}$$

Example: Even Cash Flows

Project Details:

• Initial Investment: ₹100 lakh
• Annual Cash Flow: ₹25 lakh (constant each year)

Calculation: $$Payback = \frac{₹100\ lakh}{₹25\ lakh} = 4\ years$$

Interpretation: The investment is recovered in 4 years.

Calculating Payback with Uneven Cash Flows

Method: Cumulative Cash Flow Approach

Step 1: Calculate cumulative cash flows year by year Step 2: Find the year where cumulative CF turns positive Step 3: Calculate exact payback using interpolation

Example: Uneven Cash Flows

Project Data:

• Initial Investment: ₹80 lakh
• Year 1 CF: ₹20 lakh
• Year 2 CF: ₹25 lakh
• Year 3 CF: ₹30 lakh
• Year 4 CF: ₹35 lakh
• Year 5 CF: ₹40 lakh

Calculation:

Observation: Payback occurs between Year 3 and Year 4

Exact Calculation: $$Payback = 3 + \frac{₹5\ lakh}{₹35\ lakh} = 3 + 0.14 = 3.14\ years$$

Interpretation: Investment is recovered in approximately 3 years and 2 months.

Decision Rules for Payback

Accept/Reject Criterion

What is “Maximum Acceptable”?

No universal standard. Companies set their own based on:

• Industry norms
• Company risk appetite
• Capital availability
• Strategic importance

Typical Payback Standards

Comparing Multiple Projects

Scenario: Two mutually exclusive projects

Decision: If using only payback, choose Project A (faster payback)

Discounted Payback Period

The Problem with Simple Payback

Simple payback ignores the time value of money.

Example: ₹10 lakh received in Year 1 is treated the same as ₹10 lakh received in Year 5.

But ₹10 lakh today is worth more than ₹10 lakh in 5 years!

Definition

Discounted payback period is the time required to recover the initial investment from discounted cash flows.

Calculation Method

Step 1: Discount each year’s cash flow to present value Step 2: Calculate cumulative discounted cash flows Step 3: Find when cumulative discounted CF turns positive

Example: Discounted Payback

Project Data:

• Initial Investment: ₹80 lakh
• Required Return: 12%
• Cash flows: Same as previous example

Calculation:

Discounted Payback: $$Payback = 3 + \frac{₹20.85L}{₹22.26L} = 3 + 0.94 = 3.94\ years$$

Comparison

Key Insight: Discounted payback is always longer than (or equal to) simple payback.

Advantages of Payback Methods

1. Simplicity

• Easy to calculate
• Easy to understand
• No complex formulas
• Quick decision-making

2. Risk Indicator

Shorter payback = Lower risk (generally)

Logic:

• Faster recovery reduces exposure
• Early cash flows are more certain
• Less time for things to go wrong

3. Liquidity Focus

For cash-strapped companies:

• Getting money back quickly matters
• Supports reinvestment
• Maintains financial flexibility

4. Screening Tool

First filter for projects:

• Quickly eliminate non-starters
• Focus detailed analysis on promising projects

5. Intuitive Appeal

Business owners understand:

• “I get my money back in 3 years”
• Clear, tangible benchmark

Limitations of Payback Methods

1. Ignores Cash Flows After Payback

Critical Flaw:

Payback says: Both are equal (3 years) Reality: Project B is far superior!

2. Ignores Time Value of Money (Simple Payback)

₹1 today ≠ ₹1 in 5 years

Discounted payback fixes this, but still has other limitations.

3. Arbitrary Cutoff

No objective criterion:

• Why 3 years and not 3.5 years?
• Different companies use different cutoffs
• No theoretical basis

4. Bias Against Long-Term Projects

Strategic projects penalized:

• R&D investments
• Infrastructure
• Brand building

These may have longer payback but create significant long-term value.

5. No Measure of Profitability

Payback doesn’t tell:

• How profitable is the project?
• How much value is created?
• Is return adequate for risk?

Payback vs NPV vs IRR

Comparison Table

When Payback Adds Value

Use payback alongside NPV/IRR when:

• Liquidity is critical
• High uncertainty after payback period
• Technology obsolescence risk
• Quick screening needed

Integrated Approach

Best Practice:

1. Screen with payback (eliminate non-starters)
2. Evaluate with NPV/IRR (measure value)
3. Consider payback as risk indicator
4. Make decision holistically

Payback in Indian Business Context

Why Payback is Popular in India

Survey findings: 85-90% of Indian companies use payback method

Reasons:

1. Risk aversion: Indian promoters prefer quick recovery
2. Uncertainty: Economic/political volatility
3. Family businesses: Conservative approach
4. Simplicity: Accessible to non-finance managers
5. Liquidity focus: Cash constraints common

Industry-Specific Norms

MSME Perspective

For small businesses:

• Payback is often the primary method
• Limited resources for complex analysis
• Cash flow management critical
• Short planning horizons

Typical MSME payback expectation: 2-3 years

Practical Applications

Application 1: Equipment Replacement

Scenario: Replace old machine with new efficient one

Old Machine:

• Operating cost: ₹15 lakh/year
• Remaining life: 5 years

New Machine:

• Cost: ₹40 lakh
• Operating cost: ₹5 lakh/year
• Life: 10 years

Annual Savings: ₹15L - ₹5L = ₹10 lakh

Simple Payback: ₹40L ÷ ₹10L = 4 years

Decision: If company accepts 4-year payback, proceed with replacement.

Application 2: Cost Reduction Project

Investment: ₹25 lakh for automation Annual cost saving: ₹8 lakh Payback: 25 ÷ 8 = 3.125 years

Quick assessment: Reasonable payback for automation project.

Application 3: New Product Launch

R&D + Launch Cost: ₹200 lakh

Projected Cash Flows:

• Year 1: ₹30 lakh
• Year 2: ₹50 lakh
• Year 3: ₹70 lakh
• Year 4: ₹80 lakh
• Year 5+: ₹100 lakh/year

Cumulative Analysis:

Payback: 3 + (50/80) = 3.625 years

Assessment: Acceptable for new product (typically 3-5 years)

Excel Calculation Tips

Simple Payback (Even CF)

=Initial_Investment/Annual_CF

Payback with Uneven CF

Step 1: Create cumulative CF column Step 2: Use MATCH to find last negative cumulative Step 3: Interpolate

=MATCH(1,IF(Cumulative_CF>=0,1,0),0)-1+
ABS(INDEX(Cumulative_CF,MATCH(1,IF(Cumulative_CF>=0,1,0),0)-1))/
INDEX(Annual_CF,MATCH(1,IF(Cumulative_CF>=0,1,0),0))

Discounted Payback

Add discount factor column:

Discount Factor = 1/(1+rate)^year
Discounted CF = Annual CF × Discount Factor

Then apply same cumulative approach.

Key Takeaways

1. Payback answers “when do I get my money back” – Simple, intuitive
2. Simple payback ignores time value – Use discounted payback for better accuracy
3. Major flaw: Ignores post-payback cash flows – Can mislead
4. Best used as screening tool – Not sole decision criterion
5. Popular in India – Aligns with risk-averse business culture
6. Combine with NPV/IRR – For comprehensive analysis
7. Lower payback ≈ Lower risk – But not always better return

Disclaimer

This article is for educational purposes only. Payback period alone is not sufficient for investment decisions. Always use multiple evaluation methods. This is not investment advice.

Frequently Asked Questions

Q: What is a good payback period? A: Depends on industry and company. Generally, 2-5 years for most business investments. Infrastructure may accept longer.

Q: Should I use simple or discounted payback? A: Discounted payback is theoretically better (considers time value). Use simple for quick screening, discounted for more accuracy.

Q: Can payback period be less than 1 year? A: Yes. High-return projects may recover investment within months. Example: Marketing campaign with immediate sales impact.

Q: What if cash flows are negative in some years? A: Calculate cumulative CF considering negatives. Payback is when cumulative permanently turns positive.

Q: Why do sophisticated companies still use payback? A: Risk indicator, quick screening, communication simplicity, and liquidity assessment. Used alongside NPV/IRR, not instead of.

Q: Can payback be infinity? A: If project never recovers investment (perpetual loss-maker), payback doesn’t exist or is infinite.

Payback period is like checking the weather before a long journey—it’s a useful quick check, but you shouldn’t plan your entire trip based solely on it. Use payback for initial screening and risk assessment, but rely on NPV and IRR for the final decision.