Payback Period Formula, Example, Analysis, Conclusion, Calculator

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. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. It is an important calculation used in capital budgeting to help evaluate capital investments. 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. For example, if a payback period is stated as 2.5 years, it means it will take 2.5 years to get your entire initial investment back. 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.

How to Calculate Payback Period in Excel – for non-regular cash flow returns

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. It also doesn’t consider cash inflows beyond the payback period, which are still relevant for overall profitability. For example, a firm may decide to invest in an asset with an initial cost of $1 million. Over the next five years, the firm receives positive cash flows that diminish over time. As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3.

The Financial Modeling Certification

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. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. Like the examples above, companies can use this tool to estimate the risk of a new project. If a business owner wants to invest money in a new piece of machinery, they could use these formulas to estimate how long it would take the cash flow resulting from the equipment to recoup the initial losses.

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. In this case, the payback period would be 4 years because 200,0000 divided by 50,000 is 4. You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one. 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.

According to payback method, the project that promises a quick recovery of initial investment is considered desirable. 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 would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less. Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years.

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. This can be a problem for investors choosing between two projects on the basis of the payback period alone. One project might be paid back faster, but – in the long run – that doesn’t necessarily make it more profitable than the second. Some investments take time to bring in potentially higher cash inflows, but they will be overlooked when using the payback method alone.

How To Calculate

The payback period is a method commonly used by investors, financial professionals, and corporations how to calculate marginal cost to calculate investment returns. You can use the tool just to estimate how long a debt or investment will take to be paid off. However, if you are evaluating a future investment, it is a good idea to have a maximum Payback Period already set. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.

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. 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.

Use Excel to Make Informed Investment Decisions

Use Excel’s present value formula to calculate the present value of cash flows. The payback period calculation doesn’t account for the time value of money or consider cash inflows beyond the payback period, which are still relevant for overall profitability. Therefore, businesses need to use other financial metrics in conjunction with payback period to make informed investment decisions. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.

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. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. 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.

• If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment.
• We believe that sustainable investing is not just an important climate solution, but a smart way to invest.
• Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached.
• However, if you are evaluating a future investment, it is a good idea to have a maximum Payback Period already set.
• Acting as a simple risk analysis, the payback period formula is easy to understand.
• As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

Example 2: Uneven Cash Flows

By following these simple steps, you can easily calculate the payback period in Excel. Using Excel provides an accurate and straightforward way to determine the profitability of potential the historical cost principle requires that when assets are acquired investments and is a valuable tool for businesses of all sizes. Given its nature, the payback period is often used as an initial analysis that can be understood without much technical knowledge.

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.

• The above article notes that Tesla’s Powerwall is not economically viable for most people.
• 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.
• Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries.
• 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.
• One way corporate financial analysts do this is with the payback period.
• •   Downsides of using the payback period include that it does take into account the time value of money or other ways an investment might bring value.

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. 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. 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. One way corporate financial analysts do this is with the payback period.

Comparison of two or more alternatives – choosing from several alternative projects:

Payback period is a quick and easy way to assess investment opportunities and risk, takt time vs cycle time vs lead time 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. Therefore, an investment with a shorter payback period might not be as good of a deal as it seems.

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. 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.

Discounted Payback Period (DPP)

However, a shorter payback period doesn’t necessarily mean an investment will generate a high return or that it is risk-free. Additionally, if the payback period is longer than the expected useful life of the project, the investment is not profitable. It’s essential to consider other financial metrics in conjunction with payback period to get a clear picture of an investment’s profitability and risk. 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.

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. Knowing the payback period is helpful if there’s a risk of a project ending in the future. For example, if a company might lose a lease or a contract, the sooner they can recoup any investments they’re making into their business the less risk they have of losing that capital.