What Payback Period Is

The payback period of an investment is essentially a measure of how long it takes to break even on the cost of that investment. In other words, how many weeks, months, or years does it take to earn the investment capital that was laid out for a project or a piece of equipment?

Obviously, those projects with the fastest returns are highly attractive. The technique for determining payback period again lies within present value; however, instead of solving the present-value equation for the present value, the cost and benefit cash flows are kept separate over time.

First, the project's anticipated benefit and cost are tabulated for each year of the project's lifetime. Then, these values are converted to present values by using the present-value equation, with the firm's discount rate plugged in as the discount factor. Finally, the cumulative total of the benefits (at present value) and the cumulative total of the costs (at present value) are compared on a year-by-year basis. At the point in time when the cumulative present value of the benefits starts to exceed the cumulative present value of the costs, the project has reached the payback period. Ranking your equipment and technology options for an intended application then becomes a matter of selecting those project options with the shortest payback period. So for example, if we compare a rotary drum filter versus a centrifuge for a dewatering application, an overall payback period for each option can be determined based on capital investment for each equipment, operating, maintenance, power costs, and other factors.

Although this approach is straightforward, there are dangers in selecting technology or equipment options based upon a minimum payback-time standard. For example, because the equipment's use generally extends far into the future, discounting makes its payoff period very long. Because the payback period analysis stops when the benefits and costs are equal, the projects with the quickest positive cash flow will dominate. Hence, for a project, with a high discount rate, the long-term costs and benefits may be so far into the future that they do not even enter into the analysis. In essence, the importance of life-cycle costing is lost in using the minimum payback-time standard, because it only considers costs and benefits to the point where they balance, instead of considering them over the entire life of the project or piece of solids-liquid separations equipment.

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