Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment. The payback period also facilitates side-by-side analysis of two competing projects. If one has a longer payback period than the other, it might not be the better option. Payback period is used not only in financial industries, but also by businesses to calculate the rate of return on any new asset or technology upgrade. For example, a small business owner could calculate the payback period of installing solar panels to determine if they’re a cost-effective option.

If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can’t be applied. This formula ignores values that arise after the payback period has been reached. 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. Managers who are concerned about cash flow want to know how long it will take to recover the initial investment. Managers may also require a payback period equal to or less than some specified time period.

1. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment.
2. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.
3. The purchase of machine would be desirable if it promises a payback period of 5 years or less.
4. Payback period is a quick and easy way to assess investment opportunities and risk, but instead of a break-even analysis’s units, payback period is expressed in years.

However, there are additional considerations that should be taken into account when performing the capital budgeting process. Machine A would pay back the initial investment in 5 years ($25,000/$5,000 per year) while machine B would pay back the initial investment in 4 years ($36,000/ $9,000 per year). So if we are just looking at the payback period, we would pick machine B, even https://simple-accounting.org/ though it costs more than machine A! The initial cash outlay is higher, but the money would be brought back into the company quicker. There may be other factors in play, but this method would encourage purchasing the more costly machine. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself.

The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money. Payback period is a quick and easy way to assess investment opportunities and risk, but instead of a break-even analysis’s units, payback period is expressed in years. The shorter the payback period, the more attractive the investment would be, because this means it would take less time to break even. The payback period is the amount of time it would take for an investor to recover a project’s initial cost.

For the most thorough, balanced look into a project’s risk vs. reward, investors should combine a variety of these models. For instance, in the example above, Rs 20 Lakhs invested might seem profitable today. However, such an investment made over a period of say 10 years may not hold the same value.

Typical cash outflows include the initial investment in the equipment or project, including any installation costs or additional capital needed. Cash inflows may include the salvage value of the equipment, if any, increase in revenues and decreases in expenditures. The payback method10 evaluates how long it will take to “pay back” or recover the initial investment.

How to calculate payback period

Refer to Figure 8.2, Figure 8.4, and Figure 8.5, and Table 8.1 as you learn what Mike’s findings are. By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform. 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. Financial modeling best practices require calculations to be transparent and easily auditable.

Example of Payback Period

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. It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. This method, along with the net present value method and the internal rate of return method, all  use cash flows to determine decisions.

Payback Period is the number of years it takes to recover the initial investment or the original investment made in a project. It is based on the incremental cash flows from a particular investment project. 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.

Payback Period Calculation

If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company tax information for nonprofits would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less. To determine how to calculate payback period in practice, you simply divide the initial cash outlay of a project by the amount of net cash inflow that the project generates each year.

The payback method evaluates how long it will take to “pay back” or recover the initial investment. The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflow(s) for the investment. Although this method is useful for managers concerned about cash flow, the major weaknesses of this method are that it ignores the time value of money, and it ignores cash flows after the payback period. Although it is simple to calculate, the payback period method has several shortcomings. Suppose that in addition to the embroidery machine, Sam’s is considering several other projects. For both of these projects, Sam’s estimates that it will take five years for cash inflows to add up to $16,000.

What Is the Formula for Payback Period in Excel?

Thus, various investment proposals are evaluated based on the number of years it takes for a business entity to recover the initial cost of the investment proposal. Typically, the investment project with a shorter pay back period is preferred over alternate investment projects. Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project’s process. For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years. In this case, the payback method does not provide a strong indication as to which project to choose. As the equation above shows, the payback period calculation is a simple one.

Advantages of the Payback Method

Hence, the payback period is not a useful method to measure profitability. Say, Kapoor Enterprises is considering investments A and B each requiring an investment of Rs 20 Lakhs today and cash flows at the end of each of the following 5 years. Let’s evaluate how much time does it take to get this initial investment of Rs 20 Lakhs back in each of the projects. 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). Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period.

When we talk about the payback method, it is important to have a couple of pieces of information. We will also need to know what our net cash flow per year will be with this purchase. With this information, we can figure out how many years it will take to get our initial investment back. Alternative measures of “return” preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.