Close this search box.

Payback method formula, example, explanation, advantages, disadvantages

The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. Payback period is a financial or capital budgeting method that calculates the number of days required for an investment to produce cash flows equal to the original investment cost.

If the discounted payback period of a project is longer than its useful life, the company should reject the project. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period. 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.

  1. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow.
  2. The cash savings from the new equipment is expected to be $100,000 per year for 10 years.
  3. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes.
  4. Use Excel’s present value formula to calculate the present value of cash flows.
  5. By the end of Year 3 the cumulative cash flow is still negative at £-200,000.

It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes. A project 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. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. Project Beta shows a faster recovery of the initial investment, indicating a shorter payback period compared to Project Alpha.

Payback Period Example

In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven. This time-based measurement is particularly important to management for analyzing risk. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital.

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. 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. Generally speaking, an investment can either have a short or a long payback period. 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.

It is easy to calculate and is often referred to as the “back of the envelope” calculation. Also, it is a simple measure of risk, as it shows how quickly money can the importance of a startup business plan be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process.

Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments. The main reason for this is it doesn’t take into consideration the time value of money. Theoretically, longer cash sits in the investment, the less it is worth. In order to account for the time value of money, the discounted payback period must be used to discount the cash inflows of the project at the proper interest rate. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. You can use a simple formula to find out how soon an investment will pay for itself.

Maybe you’d like to purchase a new building, but you’re unsure if the savings will be worth the investment. Calculating the payback period for the potential investment is essential. While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment. That’s what the payback period calculation shows, adding up your yearly savings until the $400,000 investment has been recouped. Any time a business purchases an expensive asset, it’s an investment.

Understanding the Payback Period and How to Calculate It

The payback period with the shortest payback time is generally regarded as the best one. This is an especially good rule to follow when you must choose between one or more projects or investments. The reason for this is because the longer cash is tied up, the less chance there is for you to invest elsewhere, and grow as a business. Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash.

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. 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.

Irregular Cash Flow Each Year

When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods.

Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator. The study of cash flow provides a general indication of solvency; generally, having adequate cash reserves is a positive sign of financial health for an individual or organization.

In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples. 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. Management then looks at a variety of metrics in order to obtain complete information. Comparing various profitability metrics for all projects is important when making a well-informed decision.

Interpreting payback period results helps you understand how long it will take to get back the money you put into a project. If the payback period is short, this means you’ll recover your costs quickly. Just add up each period’s cash flow with the total from previous periods to get this number. Next, check that your cash flow predictions are ready for each period after the investment.

Illustrative Payback Period Example

Accountants must consider this metric along with others such as IRR and NPV to ensure a comprehensive financial analysis. Despite its limitations, payback period analysis remains a key tool for initial screening of investment opportunities. Comparing investment options with payback period analysis offers a straightforward perspective on potential returns. Investment professionals often use the payback period to gauge the risk and liquidity of various projects or assets by determining how quickly they can recoup their initial outlay. Start by collecting all the financial details of your investment project.

However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000. 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.