Capitalisation rates and multipliers are frequently used in property valuation. They are relatively quick and easy to use. However, they do not directly consider the time value of money and risk factors and they focus on a single year’s income.
The payback (PB) period technique determines the time period that is expected to elapse before the initial cash outlay of an investment is returned to the investor through the future net cash inflows arising from the investment. If the future annual net cash inflows are the same each year, the payback period in years can be represented by the formula:
PB = Equity capital outlay/Annual net equity cash flows
If the annual net cash flows are expected to vary from year to year, they have to be added together, starting with year 1 cash flows, until their aggregate reaches the initial outlay.
|A property owner is considering installing a sensory security system to replace the services provided by a security firm. The new system will cost $50,000. The system will have a 10-year effective life. The annual savings in fees paid to the security firm will be $14,000.
What is the payback period of the sensory security system?
The payback system has important drawbacks. It ignores the fact that a dollar today is worth more than a dollar in the future. It also ignores all cash flows beyond the payback period.
It is popular because it is relatively easy to calculate. However, it should only be used in conjunction with other valuation techniques. If used alone, it could result in an investor rejecting an investment opportunity with a strong positive net present value where the majority of the cash inflows occur beyond the payback period.