Explanation:When management is considering whether or not to purchase new assets, they typically favor investments with 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 itself 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.
In a nutshell:
- The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point.
- Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.
- The payback period is calculated by dividing the amount of the investment by the annual cash flow.
- Account and fund managers use the payback period to determine whether to go through with an investment.
- One of the downsides of the payback period is that it disregards the time value of money.