# Payback Period: Definition, Formula & Examples

The project’s payback occurs the year (plus a number of months) before the cash flow turns positive. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. That’s why business owners and managers need to use capital budgeting techniques to determine which projects will deliver the best returns, and yield the most profitable outcome. Payback period is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful.

- Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.
- A capital project is usually defined as buying or investing in a fixed asset which, by definition, will last more than one year.
- The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability.
- The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project.
- Despite its appeal, the payback period analysis method has some significant drawbacks.

The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years.

For example, three projects can have the same payback period; however, they could have varying flows of cash. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects. By forecasting free cash flows into the future, it is then possible to use the XIRR function in Excel to determine what discount rate sets the Net Present Value of the project to zero (the definition of IRR). 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. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method.

Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach. Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater.

## Payback period

It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. There are two steps involved in calculating the discounted payback period. First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value. Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it.

The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes. The opposite stands for investments with longer payback periods – they’re less useful and less likely to be undertaken. In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs). As the equation above shows, the payback period calculation is a simple one.

## Payback period formula for even cash flow:

When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. The payback period formula’s main advantage is the “quick and dirty” result it provides to give management some sort of rough estimate about when the project will pay back the initial investment. Even with the more advanced methods available, management may choose to rely on this tried and true method for the sake of efficiency. There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period. A payback period refers to the time it takes to earn back the cost of an investment.

Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached. Some companies rely heavily on payback period analysis and only consider investments for which the payback period does not exceed a specified number of 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.

Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. 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. Others like to use it as an additional point of reference in a capital budgeting decision framework. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program.

Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total. These two calculations, although similar, may not return the same result due to the discounting of cash flows. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest.

## Payback Period Formula

This formula ignores values that arise after the payback period has been reached. For example, a firm may decide to invest in an asset with an initial cost of $1 million. Over the next five years, the firm receives positive cash flows that diminish over time. As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3.

## What is the Discounted Payback Period?

Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path.

## Decision Rule

The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues. The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance.

A capital project is usually defined as buying or investing in a fixed asset which, by definition, will last more than one year. Current projects last less than one year, and companies typically show these costs as an expense wave reviews on the income statement, rather than as a capitalized cost on the balance sheet. 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).

One of the biggest advantages of the payback period method is its simplicity. The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time.

A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time. The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost. A project https://www.wave-accounting.net/ 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. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.

## Leave a Reply