7.7 : Payback Period

The payback period is a financial metric used to measure the time required to recover the cost of a project or investment. It is calculated by dividing the initial investment by the expected annual cash inflows, offering a simple way to assess how quickly the investment will be repaid.

For example, imagine a bakery owner who invests $15,000 in a new oven. The oven is expected to generate an additional $3,000 annual cash inflows from increased production for several years. By dividing the $15,000 investment by the $3,000 yearly inflows, the payback period is determined to be five years. This means the bakery will recover the initial $15,000 investment in five years.

After the five-year payback period, the oven will continue generating cash inflows, further boosting the bakery's profitability.

The payback period helps the owner understand how long it will take to recover the investment, making it a useful tool for evaluating risk and financial decision-making. Although it does not account for the time value of money or long-term profits, it provides a quick overview to aid in resource allocation and planning.