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Generally, the payback period is expressed in years. All other factors held equal, a shorter payback period is more desirable than a longer payback period.
The payback period is a simple method of evaluating the risk of an investment.
The Payback Period Formula
The formula for determining the payback period is fairly straightforward: divide the initial cash spent for the investment by the amount of net cash flow expected to be generated by the project per year.
In this equation, we assume that the initial cash outlay occurs in its entirety at the beginning of the acquisition, and the annual cash flow remains the same each year.
Advantages of Using the Payback Period for Buying a Business
The payback period method of analyzing an investment’s break even point is popular due to its simplicity and its ability to apply to and compare nearly any investment.
From a risk analysis perspective, the payback period offers a snapshot of the total amount of time that the investment will remain at risk.
Disadvantages of Using the Payback Period for Buying a Business
Though the payback method is widely accepted as a reliable method for determining an investment’s break even point, it’s also important to be aware of the formula’s shortcomings.
Listed below are some disadvantages of using the payback method.
- Time value of money – Time value of money is not considered, so cash generated in later years won’t accurately reflect its value at the time. The discounted payback formula (a variation that takes into account the time value of money) can be used to eliminate this issue.
- Equal annual cash flow – This equation assumes that the investment will generate equal annual cash flow each year until the break even point is reached. If the actual cash flow generated is weighted heavily either at the beginning or end of the payback period, it will cause the payback period method to be inaccurate.
- Profitability – The payback period for buying a business doesn’t take into account profitability after the break even point is reached. While we might assume that an investment with a shorter payback period is preferred to an investment with a longer payback period, this may not hold true if the investment with a shorter payback period offers little or no long-term profitability potential. Conversely, an investment with a longer payback period but higher long-term profitability potential may be more desirable.
Despite its shortcomings, the payback period method provides a straightforward and simple method of determining an investment’s break even point and number of years it will take to begin producing a positive cash flow for the buyer as a result of the acquisition.
Assuming buyers keep the disadvantages of this method in mind, the payback method can prove to be a fairly useful tool when evaluating multiple businesses for sale.