Payback Method for Calculating Return on Investment

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Table of Contents

Introduction
Calculations
Discussions and conclusions
References

Introduction

In every investment, resources are expended in which we expect some returns or at least some value back to justify our cause for using up what we have. In any case, any investment should be worthwhile before we fully commit ourselves to spend. There are various methods upon which we can use to determine whether the undertaking upon which we are about to use our hard-earned resources is worthwhile. One such method is the payback period. The payback period simply means the period or the time required by use to recoup back or recover our investment (Fields, 2011; Brigham & Ehrhardt, 2010).

This method does not prove whether it is worthwhile to undertake a particular investment when we are only evaluating a single project but it often very useful when one has several alternatives to take (Ross, Westerfield & Jaffe, 2006). For this case, in particular, using the payback method to calculate the period it will take us to recoup our investment in ovens gives the following;

Calculations

Year	Beginning unrecovered investment (1)	Investment (2)	Cash Inflow (3)	Ending unrecovered investment (1) + (2) –(3)
1	0	$38,000	$2,000	$36,000
2	$36,000	$6,000	$4,000	$38,000
3	$38,000		$8,000	$30,000
4	$30,000		$9,000	$21,000
5	$21,000		$12,000	$9,000
6	$9,000		$10,000	$1,000
7	$1,000		$8,000	0
8	0		$6,000	0
9	0		$5,000	0
10	0		$5,000	0

Discussions and conclusions

From the investment, we need to invest $38,000 and $6,000 for the first and second year respectively which yields a total of $44,000 total investment. Using the given cash inflow, it will take us a total of 7 years to fully recoup the investment we make as shown in the above calculation.

It would simply matter less if during the 9^th or 10^th year the earnings were several times higher as far as the payback period is concerned. As I earlier alluded, the payback period only takes into consideration the period required to recoup back our investment. Since we would have already gotten back our total investment by the seventh year, subsequent earnings in subsequent years would matter less in our decision making if we were to solely use the method. A combination with other methods of evaluating an investment such as the internal rate of return and the net present value could be very useful in making an informed decision (Brigham & Ehrhardt, 2010; Warner & Stoner, 2006).

References

Brigham, E. F. and Ehrhardt, M. C. (2010). Financial Management: Practice and Theory, 13E. Cengage Learning, New York.

Fields, E. (2011). The Essentials of Finance and Accounting for Nonfinancial Managers, 2^nd E. AMACOM Div, American Management Association, New York.

Ross, S. A., Westerfield, R. and Jaffe, J. (2006). Corporate finance. McGraw Hills/Irwin, New York.

Werner and Stoner (2006). Modern Financial Managing, McGraw Hills, New York.

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Payback Method for Calculating Return on Investment

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