Payback Period: Definition, Formula, and Calculation

If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly. On the other hand, an investment with a short lifespan could need replacement shortly after its payback period, making it a potentially poor investment. 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.

• Average cash flows represent the money going into and out of the investment.
• Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
• Let us understand the concept of how to calculate payback period with the help of some suitable examples.
• First, it ignores the time value of money, which is a critical component of capital budgeting.
• Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible.

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The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven. A shorter period implies lower risk, as capital is recovered quickly, minimizing exposure to uncertainties like market volatility or regulatory changes. For example, strategic investments in research and development may have longer payback periods but are critical for fostering innovation and maintaining competitive advantage. Interpreting the payback period requires considering industry norms and organizational goals.

COMPANY

Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. The payback period calculation doesn’t account for the time value of money or consider cash inflows beyond the payback period, which are still relevant for overall profitability. Therefore, businesses need to use other financial metrics in conjunction with payback period to make informed investment decisions.

The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back, and the company’s earnings potential is greater. Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. However, a good payback period is one that is short enough so that the investment can start generating an income sooner. This allows the company to reinvest that money and see a return on their investment quicker. This still has the limitation of not considering cash flows after the discounted payback period.

Payback Period (Payback Method)

Using that number, along with the projected cost of their student loans, they can project how long it will take before they have recovered their investment. In this formula, the net cash flow would be over the course of the set payback period. Also, in order to use this formula, the net cash flow must remain equal over each period of payments.

The payback period is a simple measure of how long it takes for a company to recover its initial investment in a project from the project’s expected future cash inflows. As such, it should not be used alone as an investment appraisal technique – other methods should be used such as ROI, NPV or IRR. In its simplest form, the payback period is calculated by dividing the initial investment by the annual cash inflow.

Payback Period and Capital Budgeting

The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay—as measured in after-tax cash flows. For example, if a payback period is stated as 2.5 years, it means it will take 2.5 years to get your entire initial investment back. Using the averaging method, the initial amount of the investment is divided by annualized cash flows an investment is projected to generate.

• Whether you’re new to investing or already have a portfolio started, there are many tools available to help you be successful.
• 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.
• It is calculated by dividing the investment made by the cash flow received every year.
• The payback period is an essential financial metric that indicates the time required for an investment to recoup its initial cost.
• Knowing the payback period is helpful if there’s a risk of a project ending in the future.
• Use Excel’s present value formula to calculate the present value of cash flows.

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. The payback period calculation is straightforward, and it’s easy to do in Microsoft Excel. This formula calculates the average yearly return of an investment over multiple years. Go a level deeper with us and investigate the potential impacts of climate change on investments like your retirement account.

Cash outflows include any fees or charges that are subtracted from the balance. The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches 4 solutions to business cash flow problems a breakeven point. You can use the Payback Period calculator below to quickly estimate the time needed to get a return on investment by entering the required numbers. As a student is deciding on a degree, they can research the average income from a career with that degree.

This calculator is useful for investors taxes on 401k withdrawals and contributions comparing different projects, businesses evaluating capital investments, and startups analyzing profitability over time. As you become more comfortable with it, you can add more sophisticated features NPV, IRR, and Payback period calculations. To calculate the payback period, you need to know the initial investment amount, the net cash flow per period, and the number of periods before investment recovery. With these numbers, you can use the calculator above to estimate the payback period.

How to Calculate NPV in Excel

Calculating payback periods is especially important for startup companies with limited capital that want to be sure they can recoup their money without going out of business. Companies also use the payback period to select between different investment opportunities or to help them understand the risk-reward ratio of a given investment. Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project.

Analysis

This works well if cash flows are predictable or expected to be consistent over time, but otherwise this method may not be very accurate. 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). 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. 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. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.

For instance, if a company’s WACC is 8%, future cash inflows are discounted at this rate, typically extending the payback period compared to the non-discounted method. Longer payback periods are not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future. For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs. That’s why a shorter payback period is always preferred over a longer one.

Payback Method Example #2

It is one of the simplest capital budgeting techniques and, for this reason, is commonly used to evaluate and compare capital projects. Unlike stable cash inflows, variable cash flows require a more detailed approach to determine the recovery timeline accurately. These variations can result from seasonal sales patterns, fluctuating demand, or changes in operational costs. There are also disadvantages to using the payback period as a primary factor when making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period with varying break-even points because of the varying flows of cash each project generates.

Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., interim financial statements project cost) and the date when the break-even point has been reached. The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. You can use the tool just to estimate how long a debt or investment will take to be paid off. However, if you are evaluating a future investment, it is a good idea to have a maximum Payback Period already set. If the periodic payments made during the payback period are equal, then you would use the first equation. Both of these formulas disregard the time value of money and focus on the actual time it will retake to pay the physical investment.

The payback period doesn’t take into consideration other ways an investment might bring value, such as partnerships or brand awareness. This can result in investors overlooking the long-term benefits of the investment since they’re too focused on short-term ROI. If earnings will continue to increase, a longer payback period might be acceptable.