The Payback Period as a Tool in Capital Budgeting Decisions

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Capital budgeting is an extremely important aspect of a business organization's financial management. Capital budgeting is defined as the "decision making process used in the acquisition of long term physical assets (Capital Budgeting , 2006, p. 1)" These long term investments can be the replacement of the current machinery, the acquisition of new equipment, establishment of new plants, introduction of new products, and investment in research and development activities…

Introduction


In order to aid managers in making decisions with regards to capital budgeting, tools and techniques have been devised. One of these methods is called the payback method. The payback method is one of the most popular tools in conducting capital budgeting decision.
The payback period tells the company the length of time required to recoup the original investment through investment cash flows. This is essentially the time when the company breaks even-the initial capital outlay is equal to the cash flows. For example, if a company invests $100,000 for the introduction of a new product line, then, the payback period reveals when the company will be generating cash flow of $100,000. Considering that the business organization invests in a project which generates the same level of cash flow annually, the payback period is computed as the follows:
However, if the investment generates unequal annual cash flows, then the individual annual cash flows are subtracted from the initial investment until a difference of zero is reached. The year when cash flow equals investment is the payback period.
Other things being equal, the investment with a low payback period is chosen as it implies less risk for the company. ...
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