Payback Period Formulas, Calculation & Examples

Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process. When cash flows are NOT uniform over the use full life of the asset, then the cumulative cash flow from operations must be calculated for each year.

#1: What is a Good Payback Period?

• It is calculated by dividing the investment made by the cash flow received every year.
• Here, future cash inflows are discounted using a particular rate, reflecting their present value.
• There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5.
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• Once you have calculated the payback period, it’s essential to interpret the results correctly.
• The payback period calculation doesn’t account for the time value of money – that is, the fact that money today is worth more than the same amount of money in the future.

The payback period is a metric in the field of finance that helps in assessing the time requirement for recovering the initial investment made in a project. It has a wide usage in the investment field to evaluate the viability of putting money in an opportunity after assessing the payback time horizon. Payback period can be defined as period of time required to recover its initial cost and expenses and cost of investment done for project to reach at time where there is no loss no profit i.e. breakeven point. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. Also, the payback calculation does not address a project’s total profitability over its entire life, nor are the cash flows discounted for the time value of money.

Payback method Payback period formula

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. 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 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.

How to Calculate Payback Period in Excel

• As such, it should not be used alone as an investment appraisal technique – other methods should be used such as ROI, NPV or IRR.
• There are two ways to calculate the payback period, which are described below.
• When cash flows are uniform over the useful life of the asset, then the calculation is made through the following payback period equation.
• 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 a stand-alone tool to compare an investment to “doing nothing,” payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).

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. The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. EnergySage, a leading online marketplace for clean energy, has revealed that the average solar shopper on their website breaks even on their solar purchase in about 7.1 years.

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The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, how the irs classifies nonprofit organizations maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. 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. Management uses the payback period calculation to decide what investments or projects to pursue. The decision rule using the payback period is to minimize the time taken for the return on investment.

For example, a large increase in cash flows several years in the future could result in an inaccurate payback period if using the averaging method. It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. Using the payback period to assess risk what is an invoice example and template is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR). This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment.

Example 1: Even Cash Flows

Considering the lifespan period of most solar systems, solar shoppers could enjoy savings or substantially reduced energy bills for almost two decades after this solar payback period. Let’s assume that a company invests cash of $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is expected to be 4 years ($400,000 divided by $100,000 per year). 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.

The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years.

COMPANY

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.

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 payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). 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. The payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it.

Generally, a long payback period is determined by your own comfort level – as long as you are paying off one investment, you’ll be less able to invest in newer, promising opportunities. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects. For lower return projects, management will only accept the project if the risk is low which means payback period must be short. 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.

In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. Now it’s time to enter the data you have gathered into the Excel spreadsheet. This sum tells you how much cash you’ve generated up until that point in time. Company C is planning to undertake a project requiring initial investment of $105 million.

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as section 179 tax deduction for 2021 follows.

Step 2: Set Up Your Excel Spreadsheet

The payback method should not be used as the sole criterion for approval of a capital investment. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. 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.