Payback Period Formulas, Calculation & Examples

This approach provides a more accurate assessment of investment value over time, especially for long-term projects. 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. Payback period is a fundamental investment appraisal technique in corporate financial management. It is a measure of how long it takes for a company to recover its initial investment in a project.

The sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.

Is the Payback Period the Same Thing As the Breakeven Point?

The decision rule using the payback period is to minimize the time taken for the return on investment. Both the above are financial metrics used for analysis and evaluation of projects and investment opportunities. Every investor, be it individual or corporate will want to assess how long it will take for them to get back the initial capital. This is because it is always worthwhile to invest in an opportunity in which there is enough net revenue to cover the initial cost. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.

What are the limitations of the payback period calculation?

In most cases, this is a pretty good payback period as experts say it can take as much as 7 to 10 years for residential homeowners in the United States to break even on their investment. We can apply the values to our variables and calculate the projected payback period for the new series. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater.

Decision Rule

A reasonable payback period also generates a faster return on investment; thus, it is an essential determinant of financial decisions. 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). Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects. By forecasting free cash flows into the future, it is then possible to use the XIRR function in Excel to determine what discount rate sets the Net Present Value of the project to zero (the definition of IRR).

What is the formula for payback period method?

This method gives a better estimate of time to break even and is applicable for assessing long-term investments. Compared to the basic payback period, this technique discounts each year’s cash flow before summing to determine when the total investment is broken even. This example uses the discounted payback period, which considers the time value of money, meaning that money received today is more valuable than the same amount received in the future. The payback period tells how long it takes for an investment to recover its cost. It is calculated by dividing the total investment by the money earned each year. The payback period is when it takes to pay back the money invested in an investment.

With these numbers, you can use the calculator above to estimate the payback period. 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. 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.

• The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability.
• The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process.
• 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.

Fortunately, with the help of Microsoft Excel, calculating the payback period can be a quick and straightforward process. 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. 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.

The implications of this are that firms may choose investments with shorter payback periods at the expense of 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. People and corporations mainly invest their money to get paid back, which is why the payback period is so important.

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. Given its nature, the payback period is often used as an initial analysis that can be understood without much technical knowledge. It is easy to calculate and is often referred to as the “back of the envelope” calculation.

It is important for players in the financial market to understand them clearly so that they can be used appropriately as and when required and get the benefit of it to the maximum possible extent. 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. Average cash flows represent the money going into and out of the investment. Inflows are any items that go payback period formula into the investment, such as deposits, dividends, or earnings.

• There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5.
• 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.
• In summary, the payback period and its variant, the discounted payback period, serve as useful initial screenings for investment projects, focusing on liquidity risk.

Here, if the payback period is longer, then the project does not have so much benefit. However, a shorter period will be more acceptable since the cost of the investment can be recovered within a short time. It is considered to be more economically efficient and its sustainability is considered to be more.

Despite the simplicity and ease of use, considering other metrics like NPV and IRR is imperative to encompassing a project’s true financial impact and ensuring a balanced investment decision-making process. The discounted payback period extends the concept of the payback period by considering the time value of money. Here, future cash inflows are discounted using a particular rate, reflecting their present value. By accumulating cumulative cash flows annually and interpolating between years when the initial investment is being recovered. The discounted payback period formula adjusts future cash flows to reflect their present value. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment.

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. 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.

Integrating payback period analysis with other financial metrics ensures comprehensive and strategic investment decisions aligned with long-term financial objectives. 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.

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. While useful for many situations, the payback period is particularly effective for investments with predictable and steady cash inflows. It may not be as effective for investments with fluctuating returns or for those that involve significant post-payback revenues. The definition of a “good” payback period varies by industry, the nature of the investment, and market conditions.

In this case, setting up a table in Excel will help evaluate and estimate the payback period. Since some business projects don’t last an entire year and others are ongoing, you can supplement this equation for any income period. For example, you could use monthly, semi annual, or even two-year cash inflow periods.