The payback period is referred to the time it takes to recoup an investment from the revenue or free cash flow it generates. This is a common investment evaluation and ranking measure used to gauge how quickly plant and equipment or capital assets purchased by businesses can repay themselves.
Some companies use the discounted payback period as a more accurate measure as this discounts the revenue or free cash flows to current dollars, this is especially useful when the payback period is longer and there are many cash flows out in future years.
Examples of Appropriate Payback periods
The appropriate payback period for investments and plant and equipment will vary depend on the industry, size of the investment, life of the plant and equipment, cost of capital and other factors.As examples only, due to our own experience within heavy industry and manufacturing operations as well as consulting with business managers we have come up with the following guide of ranges for usual payback periods: (Please note that these are examples and do not constitute financial or business advice).
Small electronic equipment: 1 - 2.5 years
Small to medium industrial plant and equipment: 1 - 3 years
Mobile plant and equipment: 2 - 5 years
Medium to large plant and equipment: 2 - 5years
Medium to large Production plant: 5 - 10 years
Large production facilities and high tech production facilities: 10 - 15 years
Large scale mining projects: 10 - 20 years
These are large ranges and can in many cases differ from company to company because of many factors. Sometimes projects such as capacity upgrades or investments in plant and equipment may have strategic motives and intangible benefits to a business, thus in fact never having a payback period or a very long unacceptable payback period. This is why the payback period should not always be the only measure used to evaluate an investment or capital investment proposition.
Example of calculating a payback period
As an example a company is looking to purchase a piece of plant for US$450 000 which will enhance production and create the following additional cash flows:
Year1: $50 000
Year 2: $80 000
Year 3:$170 000
Year 4:$170 000
In this example the payback period is 3.88 years, calculated by adding up the revenues from year one to year three this totals: US$300 000, This means that by the end of year three US$300 000 has been recouped and somewhere in the fourth year the investment is fully paid back. At the start of the fourth year US$150 000 is left to recoup the investment, to find out at what point in the fourth year the investment is fully paid off you divided US$150 000 by US$170 000 and this is 0.88, thus the payback period is 3.88.
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