Small Business Taxes & Management

Special Report

Payback Period and Capital Investments


Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.


Why analyze equipment purchases? Most small businesses rarely have excess cash, making capital investment decisions particularly critical. And even if you're sitting on a mound of cash, wasting it on equipment that isn't going to give you an adequate return makes no sense. There's a second reason for doing an analysis and that's to compare two or more different pieces of equipment that can serve the same purpose.

The best generally accepted method is the net present value (NPV) approach. The concept takes into account the time value of money (returns in later years are less valuable than earlier years) and considers returns over the life of the equipment and even salvage value. The method has two disadvantages. First, it's not the easiest to use. Unless you have a program to do the calculations or are good with a financial or scientific calculator, working through the numbers can be challenging. Second, the cash inflows (the savings or extra revenue) from the equipment are often hard to accurately predict. The solution is to use several different assumptions for the cash flows. But that increases the math load. If the you're analyzing involves a significant investment or one with a long life and complex cash flows, you've got to use a NPV approach, at least as one method.

For less expensive equipment and in certain special situations, you should consider the methods below.


Payback Period

The payback period is an old, simple method for analyzing a capital investment. By itself it doesn't predict the rate of return on the investment, only how long it will take for you to get your money back. In its simplest form, you divide the periodic cash inflows (annually or monthly) into the cost of the equipment.

Example--Madison is considering the purchase of a used forklift for $25,000. The forklift will allow Madison to move product from one end of the plant to another faster while freeing up a worker. The net cash flow savings (total savings less operating cost and maintenance on the forklift) will approximate $900 per month. The payback period is 27.8 months ($25,000/$900) or 2.3 years ($25,000/$10,800).

Thus, Madison can recover its investment in just over two years. The quicker the payback period, the less risky the investment. For many businesses that's an important consideration in the current economic climate.

The big advantage here is that even if Madison has guessed wrong and the net cash inflow is as low as half that amount, it will still recover its investment in under 5 years. Redoing the analysis using different assumptions is relatively fast.

Trying to decide between two different pieces of equipment? Pick the one with the shortest payback. That will be the least risky.

There's more than one disadvantage to the method. First, the approach does not take into account cash flows after the payback period ends. For example, assume two forklifts, one with a 2.3-year payback, a second with a 3.2-year payback. In theory you'd pick the unit with the 2.3-year payback. But assume that at the end of 3 years forklift 1 needs an engine overhaul for $8,000; forklift 2 won't incur that expense. Or assume that the two forklifts have the same payback period, but forklift 2 can be sold at the end of 5 years for $18,000; forklift one will only command $5,000.

The second disadvantage is that the payback period does not take into account the time value of money. That is, it makes no difference when the cash flows occur. This drawback becomes more of an issue when the cost of capital (e.g., interest on a loan) is high and the time frame is long. That's the main reason you can't use it on buildings or other long-lived assets.

A third disadvantage occurs when the cash flows are irregular. That can occur where the flows are subject to seasonal variations, downtime, special expenses, etc. That can be solved by looking at the cash flows on a monthly basis and subtracting them from the cost of the equipment until you hit zero.

Example--Assume a forklift costs $25,000. The monthly net cash inflows are $6,000, $7,000, $4,000, -$2,000 (the unit is in the shop for maintenance), $1,000, $2,000, $5,000, and $5,000. It would take a little under 8 months to recover the investment. (At the end of the seventh month you'd have an unrecovered cost of $2,000.)

Despite the disadvantages, the method provides guidance in risky situations and when available funds are tight. Consider the original forklift example. There's not much risk if you'll get your money back in just over 2 years. Payback period of 7 years? A lot can change in that time. And the further out you get the more difficult it is to predict cash flows. When you're trying to decide between investments when capital is rationed, a quick payback period may be the smarter choice. A forklift with a 2.5-year payback vs. a new pickup with a 6-year payback? The choice is easy.


Simple Return on Investment

This approach also ignores the time value of money, but gives you a better idea of the overall return from the investment. Here you subtract the cost of the equipment from the net cash inflows and divide that by the cost of the investment to get a total percentage return. Then divide by the number of years those inflows will be generated. The drawback here is that unless you use a number of cash flow projections, risk is not taken into account.

Example--Madison is considering the purchase of a forklift for $25,000. The unit will be kept 5 years and the total cash inflows will be $48,000 (including proceeds from the sale of the unit at the end of the period). Subtract $25,000 from $48,000 to get the positive cash inflows of $23,000. Divide that by $25,000 to get 0.92 for a total return. The annual return would be 18.4% (0.92/5).

This approach usually doesn't make sense by itself, but can be a quick way of quantifying the return after using the payback period.


Constraint Method

This approach isn't as much an analytical tool, as a way of deciding on how to allocate sparse funds. Think of it this way. You hire a graphic artist to design your packaging and ads. She needs a computer. You can either drag out that 5-year old machine from storage and spend the money you save on a new desk for your office or spend $1,500 on a fast machine that will allow the artist to get the work done without overtime. The choice should be clear.

Now consider a situation where you have 3 networked printers. It's not unusual for print jobs to back up on busy days. The situation is exasperated when multiple detailed quotes are needed. The savings from a new unit may be difficult to quantify, but you know they exist. If that's the only constraint situation in the company, a new printer would make a good investment. The only reason for not making the investment would be a lack of cash or another, higher priority, requirement. If there are other such situations, you should list them in constraining order along with the cost.



It would be nice if you could analyze all equipment purchases using a net present value or other sophisticated approach, but that's unrealistic. In some cases the cost of the analysis would outweigh the cost of the asset. Look at the constraint method first. The choice may be so clear no further analysis is needed. Use the payback method second, particularly if you can't project the cash flows accurately or there's substantial risk in the investment.

We haven't discussed the definition of cash flow here. For most small projects that's just the cash savings generated less any direct or indirect costs before any deduction for depreciation or amortization.


Copyright 2012 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. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. 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 01/03/12