Payback answers the question: How soon do I recover my cash investment?
You calculate payback as:
Stream of cash inflows divided by the original cash investment
So, if an investment produces a $100 a year for five years and the original investment is $300, then, the payback period is three years.
Payback is a useful, rough guide for assessing risk when doing any kind of IT due diligence. The longer the payback period the greater the risk.
It has limitations though:
- Says nothing about the timing of cash flows (no discounting);
- Ignores cash flows after the payback period;
- Tells you when your investment principal is paid back, but is silent on the return on your capital.
Payback is, in summary, a solid supplement to an ROI analysis built around a net present value or discounted cash flow analysis.
For more ultra-concise, practical information on IT business cases and IT due diligence, please see the The Business Case Checklist.