No matter how attractive and profitable an investment or investment project may look, one question that will surely come back in the minds of investors is how long will the capital invested recover?
Payback, investment recovery period or PRI is a financial indicator that answers that question. The payback may or may not recognize the effect of the value of money over time depending on whether the denominator of calculation considers net discounted flows or not.
The PRI or recovery period is an indicator that should not be missing in a business plan, the report of an investment project or used in conjunction with any other project analysis technique for its simplicity of calculation and analysis in the measurement of risk.
The period of recovery of the investment has its advantages and disadvantages as a means of risk assessment. The philosophy of analysis is very simple, between two projects it will be less risky if you recover the investment first.
What is the period of recovery of the investment?
The period of investment recovery, called Payback (in English) or PRI, is a method for evaluating an investment or a project that consists of determining the term or amount of time required for the net cash flows of a project exceed or recover the initial investment to be made.
The domain Accountingformanagement.org defines the recovery period in simple terms, arguing that PRI corresponds to the “period of time a project requires to recover the money invested in it.” It is very easy to calculate and is measured in years.
The criterion for the valuation of a project or investment is that among different alternatives or projects, the one that determines the shortest period of recovery of the investment will be better because it implies that the capital of the investors will be less time at risk.
That same analysis criterion that is somewhat light, as well as the fact that it does not consider the value of money over time, are the main weaknesses or limitations of the Payback. Therefore, to achieve a more exhaustive financial evaluation of an investment, the PRI must be accompanied by other indicators such as Internal Rate of Performance and Net Present Value.
Calculation of the PRI
It is said that the calculation of the period of recovery of the investment is so simple that it can be estimated with the “fingertip.” It obeys the following formula:
PRI = (Initial investment) / (Sum of annual net cash flows)
The simple recovery period is calculated by dividing the initial investment of the project by the expected annual cash flows.
In more complicated cases, which include the elimination and replacement of equipment, the salvage received from the item deposed is subtracted from the cost of the new equipment (Initial investment) and the balance or difference is used in the calculations of the period of recovery of the investment.
The basic principle of Payback is to establish the time it takes for the company to recover its initial investment, which will be the time when the initial investment is at risk.
Uses of the PRI
Mutually exclusive projects refer to substitute proposals that fulfil analogous functions and tasks. These projects have similarities in many aspects, so it is up to investors and project managers to decide on the option that best suits them based on the result of the PRI.
The recovery period, therefore, becomes a technique of choice of investment alternatives. The financial directors calculate the recovery period for the different projects and choose one with the shortest period.
Independent investments, on the other hand, are also valued from the Payback, refer to competitive projects that serve different purposes. The choice of one project does not affect the others.
Each project is independent and is considered in terms such as viability and availability of funds. The recovery period becomes an evaluation technique when monitoring projects that qualify by their nature and the expectations of investors.
Although there is no relationship between the projects, the recovery period will be the decision criterion to choose between them. This is a common practice in financially restricted companies.
Limitations of the PRI
The period of recovery of the investment is not free of defects. This method can not be used independently in the selection of investments and therefore other considerations have to be assessed, such as time, the value of money and cost-benefit compensations.
Choosing a project for only the time it takes to recover the investment can be a limited vision, since it may turn out to be the least profitable project.
It also ignores cash flows after the time of the recovery of the investment, which is important for the profitability of a company. Inconsistencies may arise between the recovery period and other investment valuation techniques. For example, the PRI can point to the option with the lowest rate of return (IRR) and present value (NPV).
The recovery period, therefore, can not sustain a significant investment decision on its own.