Payback Period
The Payback Period is the time taken for a project to recoup its initial investment. It mainly measures the time required for the net revenues of a project to return the original investment. This is usually an important factor while deciding upon the feasibility of the project. The shorter the payback period, the less risk is associated with the project, but it does not take into account any benefits that occur after the payback period and ignores the concept of time value of money. Nonetheless, it remains a simple and useful tool for initial project screening.
A Comprehensive Guide to Payback Period
What is the Payback Period?
The payback period is a fundamental concept in finance. It refers to the length of time it takes for a company or an investor to recoup the original investment.
Why is the Payback Period Important?
It is an essential tool for decision making as it helps investors and businesses measure the risk of an investment, specifically how quickly they can expect to recover their investment. Hence, it aids in assessing the liquidity risk associated with an investment.
How does it work?
The payback period is calculated by dividing the total investment cost by the annual net cash inflow.
How to Answer Questions on Payback Period in an Exam
1) Understand the scenario given in the question, calculate the total investment and the annual net cash inflow.
2) Divide total investment by annual net cash inflow. This is your payback period.
3) Interpret your result. A shorter payback period indicates a lower risk investment.
Exam Tips: Answering Questions on Payback Period
Interpret the payback period correctly. A shorter payback period means a lower risk and higher liquidity investment.
Remember to show all your calculations in the answer.
Make sure to understand the relationship between payback period and risk- the longer the payback period, the higher the risk.
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