Payback Period Learn How to Use & Calculate the Payback Period

For example, imagine a company invests $200,000 in new manufacturing equipment which results in a positive cash flow of $50,000 per year. As you can see, using this payback period calculator you a percentage as an answer. Multiply this percentage by 365 and you will arrive at the number of days it will take for the project or investment to earn enough cash to pay for itself. The discounted payback period determines the payback period using the time value of money. Below is a break down of subject weightings in the FMVA® financial analyst program.

  1. Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow.
  2. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon.
  3. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.
  4. According to payback method, the project that promises a quick recovery of initial investment is considered desirable.
  5. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

The total capital investment required for the business is divided by the projected annual cash flow to calculate this period, usually expressed in years. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period. Management uses the cash payback period equation to see how quickly they will get the company’s money back from an investment—the quicker the better. In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks. It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects.

Drawback 2: Risk and the Time Value of Money

Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. There are some clear advantages and disadvantages of payback period calculations. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered.

So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100). Jim estimates that the new buffing wheel will save 10 labor hours a week. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be.

How to Calculate Payback Period

The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back. Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number. One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year. In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV.

Payback Periods

In most cases, a longer payback period also means a less lucrative investment as well. A shorter period means they can get their cash back sooner and invest it into something else. Thus, maximizing the number of investments using the same amount of cash.

Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance.

Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. Considering 15 best practices in setting up and sending nonprofit newsletters that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash.

The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project. However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years.

As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects. The Payback Period shows how long it takes for a business to recoup an investment. This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them. The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money.

However, there are additional considerations that should be taken into account when performing the capital budgeting process. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted.

All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex.

When evaluating the payback period or determining the breakeven point in a business venture, it is crucial to consider the opportunity cost and the influence of the time value of money. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1.

The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods. According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. In such situations, we will first take the difference between the year-end cash flow and the initial cost left to reduce.