Small Business Taxes & Management

Special Report

Analyzing Investments Using Payback Period


Small Business Taxes & ManagementTM--Copyright 2021, A/N Group, Inc.


Before making a substantial investment in a piece of equipment, you should calculate how much return you'll get on your expenditure. Just because you'll get a tax deduction doesn't mean it's a smart move. And the lower the bracket you're in, the less that tax deduction is worth. That means your business is picking up most of the tab for the equipment.

In many cases you don't need to do a sophisticated, or even any, analysis. The hard drive on the six-year old computer the receptionist uses just failed. Unless you've got an extra laptop lying around, a new one is in order. It's just a question of what kind and how powerful. If you're a contractor no analysis is needed if you're thinking about investing in an extra set of batteries for your drill. The expenditure is too small to warrant even thinking about it. But a plumber who's considering a $2,500 compression tool to replace soldering copper pipes on many jobs may have have to give it some thought. Your dollar threshold for analysis depends on how big your business is.

There are a number of analysis methods. Good ones take into account the time value of money. That is, a dollar received today is worth more than money you'll get next year. For short-term investments such as a delivery truck driven 65,000 miles a year, taking into account when the returns are received may not be that important. The truck will probably be worn out after a couple of years. On the other hand a backhoe with a diesel engine could easily be in service for 15 years. A dollar even 10 years down the road is worth only $0.40 today. In addition, in many types of equipment you've got to factor in costs along the way. While the backhoe may be serviceable 15 years from now, you might have invested $30,000 to rebuild certain parts.

With long-lived equipment and more expensive items the internal rate of return or discounted cash flow models produce the best results. While the results are far more accurate, especially in complex situations, they require much more work. Cash flows from the investment must be projected over the life of the investment. A single projection for the income doesn't take into account the likelihood that the cash flows will be higher or lower. In addition, with the current rapid technological changes an investment might have a much shorter life than anticipated.

There is another approach called the payback period. It does not take into account the time value of money making it poor choice for longer-term projects. But it does provide a measure of risk evaluation. The concept is simple. How long will it take for the cash flows from the investment to equal the cost.

Example--Fred is considering buying a new lathe for $20,000 that will return about $8,000 per year in cash flow. Simply divide the $20,000 by $8,000 to arrive at 2.5 years. Thus, Fred should recover his investment in that time. You could also perform the calculation in months. In that case the cash flow would be about $666 per month. Dividing $20,000 by $666 results in 30 months.

Now for the drawbacks. The payback period doesn't take into account cash flow after payback is reached. Thus, the lathe may go on to produce returns for 20 years or it could be economically obsolete at the end of 2.5 years. Second, an investment should do more than simply return your cash outlay. That's not a good long term strategy. Third, the payback period doesn't take into account negative cash flows after the payback period ends. For example, assume at the end of 30 months cash flow goes negative because of overhaul costs. Another point. What happens if Fred has to pay $5,000 to have the lathe junked? You could build that in up front by increasing the cost of the lathe by $5,000, but that's not an attractive approach. Finally, for long-term investments you have to factor in the future value of money. Clearly, you wouldn't use the method for valuing real estate. A possible exception is if you intend to flip the property.

Despite the drawbacks, the payback period can be used profitably when you're unsure of how long you'll be able to use the equipment. For example, you have to pick one of three technologies to invest in for your network. If you pick the wrong one, your equipment will be essentially worthless. You anticipate the winner will be decided in three years. If the payback period is less than three years, at least you won't be looking at an investment disaster.

The payback period also can be used to pick between two risky investments. If they have similar discounted cash flow returns, picking the one with the shorter payback could reduce your risk.


Copyright 2021 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 12/13/21