It defines the time required for equity of an ongoing company to be equal to the original equity investment and indicates how long it will take for the Owners to recover their initial capital. Investors are interested in knowing the answer to: when the investment will “pay itself back”?
The payback period intuitively measures how long it will take to a start-up company to produce enough profits from operations so that equity in a given year becomes equal to originally invested capital or how long it takes for the firm to “pay for itself”. Shorter payback periods are preferable to longer payback periods (all else being equal), as investors consider shorter periods as being less risky.
Payback period is widely used due to its ease of use despite recognised shortcomings.
We will look at the payback period, first, in the baseline case scenario when initial price is 30,000 in Y1 and Y2, then to a second scenario when the initial price is 40,000 and to a third scenario when the initial price is 50,000.
Initial investors have a primordial interest in knowing when the firm will produce enough profits for their investment recovered. Payback is considered a measure of risk, the longer it takes to recover the initial investment the riskier the investment and vice versa. Investors prefer shorter paybacks periods than longer ones. The quicker they recover their money the better!
Management is tasked with finding the payback period under several actions and comparing it with the baseline case: (i) increase the baseline unit license price to 40,000 in Y1 and Y2; (ii) increase the baseline unit price to 50,000 in Y1 and Y2; (iii) increase the baseline quantities of licenses sold in Y1 and Y2; and (iv) reduce the baseline purchase unit cost of licenses in Y1 and Y2.
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