Definition: Payback period, also called PBP, is the amount of time it takes for an investment’s cash flows to equal its initial cost. In other words, it’s the amount of time it takes for an investment to pay for itself. This is an important time-based measurement because it shows management how lucrative and risky an investment can be.
What Does Payback Period Mean?
When management is considering whether or not to purchase new assets, they typically favor investments with a shorter payback periods. These investments are less risky because the company gets its money back quicker and can reinvest it into a new piece of equipment.
Investments with longer payback periods are most risky than ones with shorter periods because there is no way to know how the future will pan out. A manager is more likely to purchase a machine that should pay for it self in 6 months, than something that will tie up company funds for 3 years. A shorter payback period reduces the company risk of inaccurate future projections of investment cash flow.
Example
Think about it this way. Managerial accountants really have no idea what their investment is going to do in the future. They can estimate and predict what the future cash inflows will be, but there is no guarantee. For instance, they might purchase a piece of equipment under the assumption that a production contract will continue for the next 3 years, but the contract actually isn’t renewed in year two. This cuts the projected cash flows by 30 percent.
That is why shorter payback periods are almost always preferred over longer ones. The faster the company can receive its cash, the more acceptable the investment becomes.
