Payback Period Learn How to Use & Calculate the Payback Period

This issue is addressed by using DPP, which uses discounted cash flows. 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. Payback period intuitively measures how long something takes to “pay for itself.” All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below.

Use Excel’s present value formula to calculate the present value of cash flows. 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.

Illustrative Payback Period Example

So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months). First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows.

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. 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. The payback period is the time it will take for your business to recoup invested funds. 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. 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.

This means that it will actually take Jimmy longer than 6 years to get back his original investment. 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.

What is Payback Period?

The equation doesn’t factor in what’s happening in the rest of the company. Let’s say the new machine, by itself, is working wonderfully and operating at peak capacity. But perhaps it’s a huge draw on the plant’s power, and its affecting other systems. Perhaps other machines need to be shut down for extended periods in order to allow this new machine to produce.

Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased. For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month. 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 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.

What Is the Formula for Payback Period in Excel?

1. However, it’s likely he would search out another machine to buy, one with a longer life, or shelf the idea altogether.
2. 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.
3. The discounted payback period determines the payback period using the time value of money.
4. Calculating the payback period is also useful in financial forecasting, where you can use the net cash flow formula to determine how quickly you can recoup your initial investment.
5. The decision rule using the payback period is to minimize the time taken for the return on investment.

The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. It is predicted that the machine will generate $120,000 in net cash flow every year. For example, if the building was purchased mid-year, the first year’s cash flow would be $36,000, while subsequent years would be $72,000.

The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. 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. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5.

The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow. 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.

What Are the Advantages of Calculating the Payback Period?

Calculating the payback period is also useful in financial forecasting, where you can use the net cash flow formula to determine how quickly you can recoup your initial investment. Whether you’re using accounting software in your business or are using a manual accounting system, you can easily calculate your payback period. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter the payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. 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.

Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost. The above equation only works when the expected annual cash accrued expenses flow from the investment is the same from year to year. If the company expects an “uneven cash flow”, then that has to be taken into account. At that point, each year will need to be considered separately and then added up.

Here, the return to the investment consists of reduced operating costs. The payback period method is particularly helpful to a company that is small and doesn’t have a large amount of investments in play. 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 can a capital loss carry over to the next year at the internal rate of return (IRR) when comparing projects. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.