In my last two posts I discussed the financial tool, Net Present Value (NPV) in detail (NPV and NPV Example). However, often times the Payback Period method is used to evaluate a purchase or expansion project. The difference between NPV and the Payback Method is that the Payback Method doesn’t discount the future cash savings/cash inflows for the time value of money.

The formula for the Payback Method is: payback period = initial investment divided by annual savings/revenue. For example, you need to buy a new machine that will improve your efficiencies, thereby reducing your expenses by $20,000 per year for the next 6 years. The machine costs $100,000 in today’s dollars. Formula: 100,000/20,000 = 5. Therefore, using the Payback Method, you would see a “payback” on your investment by the end of the 5th year. Note: the payback method does not tell you if your purchase will provide positive profits over the long-term, but rather the length of time it will take for you to “recoup” your initial investment, ignoring the time value of money concepts.

This purchase might make sense at first look, assuming the machine will provide cost savings for more than 5 years. The Payback Method can be used to perform a first level evaluation of a potential purchase. Using the Payback Method you might determine that one purchase isn’t feasible because the payback period is just too long. However, run a quick NPV calculation to make sure the project truly isn’t profitable for your business.

As I showed in the NPV Example blog post, when you convert the $20,000 per year cost savings into their Net Present Values the true net cash flow for the investment will be a ($11,723). This is because a dollar tomorrow is less than a dollar today and the value lessens the further out in the future you go.

While the Payback Method might be easy to use, it does not take into consideration the time value of money. Relying solely on the Payback Method might result in poor purchasing decisions. A quick NPV calculation may save you the disappointment from future low returns on the cash you spend today.