The payback reciprocal is a way for your client to see if it’s worthwhile to accept a project or long-term job. It’s calculated by taking the inverse of another evaluation tool, the payback period. The ultimate goal is to come up with a really rough estimate of what your client’s rate of return will be over the life of the project.
To use the payback reciprocal, you have to first calculate your client’s payback period. This is the amount of time it takes for your client to get back all of the money it invested. If your client spent $50,000 on a project and expects to collect cash inflows of $10,000 each year, its payback period is five years. Using this information, your client’s payback reciprocal is 1 divided by 5, or 20%. This means your client can expect to have a rate of return of about 20% during the project.
There’s a couple of downsides to using the payback reciprocal. First, it assumes your client will receive steady cash flow. Payback reciprocals rely on having a constant inflow of cash. It also doesn’t incorporate the time value of money like the internal rate of return or net present value. Your client may receive less money from other projects, but those projects may actually be better because of the timing of cash flow. The payback reciprocal also doesn’t consider how long a project will run. It assumes cash flows will continue forever, which is a fairly unrealistic assumption.
The payback reciprocal is a useful tool if you’re trying to take a quick look at whether a project is worth undertaking. It had drawbacks, but it’s a simple way to get an estimated rate of return for a long-term commitment.