Pay back method does not consider the present value of cash flows. An investment is accepted or rejected according to the payback period. Payback period means the period of time that a project requires to recover the money invested in it.
The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash flow generated by the project per year (which is assumed to be the same in every year).
Payback Period Example
John is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0 years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce saw mill transport costs by $12,000 per year. The payback period for this capital investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using the payback method as the basis for its investment decision, it would buy the conveyor system, since it has a shorter payback period.