length of time required to recover the initial amount of a capital investment. If the cash inflows occur at a uniform rate, it is the ratio of the amount of initial investment over expected annual cash inflows, or:

Payback Period = Initial Investment / Annual Cash Inflows

For example, assume projected annual cash inflows are expected to be $6000 a year for five years from an investment of $18,000. The pay-back period on this proposal is three years, which is calculated as follows:

Payback period = $18,000/$6000 = 3 years. If annual cash inflows are not even, the payback period would have to be determined by trial and error. Assume instead that the cash inflows are $4000 in the first year, $5000 in the second year, $6000 in the third year, $6000 in the fourth year, and $8000 in the fifth year. The payback period would be 3.5 years. In three years, all but $3000 has been recovered. It takes one-half year ($3000/ $6000) to recover the balance. When two or more projects are considered, the rule for making a selection decision is as follows: Choose the project with the shorter payback period. The rationale behind this is that the shorter the payback period, the greater the liquidity, and the less risky the project. Advantages of the method include (1) it is simple to compute and easy to understand and (2) it handles investment risk effectively. Disadvantages of the method include (1) it does not recognize the TIME VALUE OF MONEY and (2) it ignores profitability of an investment.