Investment Analysis Methodologies - Payback Period
If you enter the mind of a Venture Capitalist, you may find amongst other things, a formula that gives him an estimate about when he can realize some profits from a startup. It is called Payback Period. It tells you, how long will it take to recover your investments and be profitable. The formula to calculate Payback Period is simple enough.
All you do is divide Investment by Annual Cash flow to get Payback Period. So suppose if Investment cost is $1,000,000 and Annual Cash Flow expected is $125,000, then Payback Period is 8 years.
However in real world, you can never expect to have a constant Annual Cash Flow every year. So, expected return for each year is added until total cost of Investment is arrived.
In the table above, Investment cost will be recovered just shy of Five years. So when a Venture Capitalist has three competing projects, he may consider Payback period amongst other things and go for the project that has the shortest Payback Period. As with any other method, this method has a disadvantage that it ignores time value of the money. However if this method is used in conjunction with the Net Present Value and Internal Rate of Return, it is a great tool for the Venture Capitalist.
As an Entrepreneur, when you prepare your projections, you must be careful with your calculations so that decision process is smoother and in your favour. Who knows, when a Venture Capitalist is comparing your project with other projects with similar merits, you may come out as a winner due to your realistic projections.
All you do is divide Investment by Annual Cash flow to get Payback Period. So suppose if Investment cost is $1,000,000 and Annual Cash Flow expected is $125,000, then Payback Period is 8 years.
However in real world, you can never expect to have a constant Annual Cash Flow every year. So, expected return for each year is added until total cost of Investment is arrived.
| Year | Return | Cummulative Project Cost |
| 1 | $125,000 | $125,000 |
| 2 | $175,000 | $300,000 |
| 3 | $225,000 | $525,000 |
| 4 | $250,000 | $775,000 |
| 5 | $250,000 | $1,025,000 |
In the table above, Investment cost will be recovered just shy of Five years. So when a Venture Capitalist has three competing projects, he may consider Payback period amongst other things and go for the project that has the shortest Payback Period. As with any other method, this method has a disadvantage that it ignores time value of the money. However if this method is used in conjunction with the Net Present Value and Internal Rate of Return, it is a great tool for the Venture Capitalist.
As an Entrepreneur, when you prepare your projections, you must be careful with your calculations so that decision process is smoother and in your favour. Who knows, when a Venture Capitalist is comparing your project with other projects with similar merits, you may come out as a winner due to your realistic projections.
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