Payback Period Explained, With the Formula and How to Calculate It

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. If undertaken, the initial investment in the project will cost the company approximately $20 million. However, one common criticism of the simple payback period metric is that the time value of money is neglected. This method helps businesses analyze different projects quickly before making financial decisions about them.

The metric is used to evaluate the feasibility and profitability of a given project. 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. 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.

1. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows.
2. Thus, the averaging method reveals a payback of 2.5 years, while the subtraction method shows a payback of 4.0 years.
3. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit.
4. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project.
5. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better.

For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment. Calculating the payback period in Excel helps businesses see how fast they get their investment back.

Using the Payback Method

The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows. At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. 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.

In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). You can lay out all your options and see which one pays back fastest using similar steps—key for smart financial decisions! By calculating each project’s payback period side-by-side in an organized fashion allows investors and analysts alike to assess various opportunities efficiently.

What is a payback period?

As a result, payback period is best used in conjunction with other metrics. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment.

Discounted Payback Period Calculation Analysis

By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform. For example, imagine a company invests £200,000 in new manufacturing equipment which results in a positive cash flow of £50,000 per year. Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money. The value obtained using the discounted payback period calculator will be closer to reality, although undoubtedly more pessimistic.

Drawback 2: Risk and the Time Value of Money

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). 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. 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.

You can use a simple formula to find out how soon an investment will pay for itself. First, you need the cost of your initial investment and your expected annual cash flows. Calculating the payback period is also useful in financial forecasting, where you can use the net cash flow formula to determine how quickly you can recoup your initial investment. Whether you’re using accounting software in your business or are using a manual accounting system, you can easily calculate your payback period. 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.

Input the known values (year, cash flows, and discount rate) in their respective cells. Use Excel’s present value formula to calculate the present value of cash flows. Next, assuming how do i start a nonprofit organization the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow.

As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. 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. 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.

The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor. The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back, and the company’s earnings potential is greater. Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money.

Did you know that although simple, the payback period is an essential tool used by finance professionals worldwide? It might not factor in every financial variable but provides a clear metric for recovery time on investments. 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 https://simple-accounting.org/ 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. 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.