How to determine the payback period of capital costs

Payback is one of the indicators reflecting the effectiveness of the economic activity of the company. It characterizes how well and successfully capital investments are used.

The essence of the payback period of capital investments

In economic analysis, there are various approaches to determining the payback period. This indicator is used as part of a comparative analysis when determining the most profitable investment option. It is worth noting that it is used only in complex analysis; it is not entirely true to take the payback period as the main parameter of effectiveness. Determining the payback period as a priority is possible only if the company is focused on a quick return on investment.

On the other hand, ceteris paribus, preference is given to those projects that have the shortest payback period.

When implementing a project on borrowed funds, it is important that the payback period be shorter than the period of use of external borrowing.

The indicator is a priority if the main priority for the investor is the return on investment, for example, the choice of ways to financially recover bankrupt enterprises.

The payback period is understood as the period during which capital costs are reimbursed. This is achieved by generating additional income (for example, when putting in more efficient equipment) or saving (for example, when introducing energy-efficient production lines). If we are talking about a country, then the compensation is due to the increase in national income.

In practice, the payback period is that time period during which the company's profit secured by capital investments is equal to the amount of investments. It can be different - month, year, etc. The main thing is that the payback period does not exceed standard values. They differ depending on the specific project and on the industry focus. For example, for the modernization of equipment at the enterprise, the normative period is one, and during the construction of the highway - another.

The calculation of the payback period should be made taking into account the time lag between capital investments and the effect of them, as well as changes in prices and other factors (inflationary processes, growth in the cost of energy resources, etc.). According to this approach, the payback period is the time period through which at the considered discount rate the positive cash flow (discounted income) and negative (discounted investment) will be equalized.