How to calculate the payback period Definition & Formula

The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. 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. You’ll need your initial investment cost and your expected annual cash flows data ready before starting your calculation in Excel. Let’s look at a real-world investment example to understand how to calculate the payback period.

1. WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted.
2. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest.
3. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year.
4. The Discounted Payback Period estimates the time needed for a project to generate enough cash flows to break even and become profitable.

This helps visually track when cumulative earnings offset the investment cost. It’s like filling up a bucket drop by drop until it overflows; each drop is your yearly profit adding up over time. In the first column, list down all the periods of your cash flow, like years or months. Next to this, enter all initial investments and incoming cash flows for these periods. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project.

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.

Understanding the Concept of Payback Period

Thus, maximizing the number of investments using the same amount of cash. A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. Are you still undecided about investing in new machinery for your manufacturing business? Perhaps you’re torn between two investments and want to know which one can be recouped faster? 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.

What is a payback period?

To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program.

With this tool, comparing different projects becomes easier since it lists everything clearly on one screen. On the other hand, Jim could purchase the sand blaster and save $100 a week from without having to outsource his sand blasting. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. how to start a virtual bookkeeping business and make $3,000 a month online 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. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach.

Calculating Payback Using the Subtraction Method

The payback period is the amount of time it would take for an investor to recover a project’s initial cost. 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. Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. After the initial purchase period (Year 0), the project generates $5 million in cash flows each year.

Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows. The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money.

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. This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment. You can use it when analyzing different possibilities to invest your money and combine it with other tools, such as the net present value (NPV calculator) or internal rate of return metrics (IRR calculator).

The implied payback period should thus be longer under the discounted method. Excel doesn’t have a dedicated “payback period” function, but you can use https://simple-accounting.org/ other functions like “CUMIPMT” or create a custom formula to find it. This is when your project has paid itself off – that’s your payback period!

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. Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. 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.

Inputting data into Excel

Therefore, it would be more practical to consider the time value of money when deciding which projects to approve (or reject) – which is where the discounted payback period variation comes in. Yes, you can use Excel to calculate the payback period by setting up a simple formula or using financial functions. In Excel, you divide the total invested money by the yearly cash flow to get the payback period. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years).

Payback period is a quick and easy way to assess investment opportunities and risk, 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. 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 payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years.

The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments. For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. 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.

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. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon.

Also, it doesn’t factor in the time value of money—a dollar today isn’t worth the same as a dollar years from now—which could lead to undervaluing longer-term gains or savings. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000.