As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. 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.
- The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in.
- Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year.
- The payback period is the amount of time it would take for an investor to recover a project’s initial cost.
- It is easy to calculate and is often referred to as the “back of the envelope” calculation.
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. 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 4 inventory costing methods for small businesses of return (IRR) when comparing projects. The decision rule using the payback period is to minimize the time taken for the return on investment. 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 above equation only works when the expected annual cash 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. 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.
Discounted payback period will usually be greater than regular payback period. Investments with higher cash flows toward the end of their lives will have greater discounting. For instance, a $2,000 investment at the start of the first year that returns $1,500 after the first year and $500 at the end of the second year has a two-year payback period. As a rule of thumb, the shorter the payback period, the better for an investment. Any investments with longer payback periods are generally not as enticing.
Example of Payback Period
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). We’ll now move to a modeling exercise, which you can access by filling out the form below. But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more.
- For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
- If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years.
- In its simplest form, the calculation process consists of dividing the cost of the initial investment by the annual cash flows.
- Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method.
- Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV.
In this article, we will explain the difference between the regular payback period and the discounted payback period. You will also learn the payback period formula and analyze a step-by-step example of calculations. Due to its ease of use, payback period is a common method used to express return on investments, though it is important to note it does not account for the time value of money. As a result, payback period is best used in conjunction with other metrics. 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.
The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, 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. 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. And this amount is divided by the “Cash Flow in Recovery Year”, which is the amount of cash produced by the company in the year that the initial investment cost has been recovered and is now turning a profit. Next, the “Unrecovered Amount” represents the negative balance in the year preceding the year in which the cumulative net cash flow of the company exceeds zero.
For example, imagine a company invests £200,000 in new manufacturing equipment which results in a positive cash flow of £50,000 per year. The payback period method is particularly helpful to a company that is small and doesn’t have a large amount of investments in play. The shortest payback period is generally considered to be the most acceptable. This is a particularly good rule to follow when a company is deciding between one or more projects or investments.
Irregular Cash Flow Each Year
One of the biggest advantages of the payback period method is its simplicity. The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time. But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting.
How to Calculate Payback Period (Step-by-Step)
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.
One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. 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. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. 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.
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. 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). 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.
When he does, the $720,000 he receives will not be equal to the original $720,000 he invested. This is because inflation over those 6 years will have decreased the value of the dollar. This means that it will actually take Jimmy longer than 6 years to get back his original investment.
Alternatives to the payback period calculation
People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter 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. The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects.
Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. The breakeven point is a specific price or value that an investment or project must reach so that the initial cost of that investment or project is completely returned. Whereas the payback period refers to the time it takes to reach the breakeven point. This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment.
The longer an asset takes to pay back its investment, the higher the risk a company is assuming. 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.
This is so the money is not tied up for too long and management can reinvest it elsewhere, perhaps in additional equipment that will generate more profit. But what if the machine for Jimmy’s Jackets will no longer be profitable past 3 years? The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time.