Payback Period: Definition, Formula, and Calculation
In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment. The decision rule using the payback period is to minimize the time taken for the return on investment. Average cash flows represent the money going into and out of the investment.
The 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. project management software The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.
Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. 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. 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. One way corporate financial analysts do this is with the payback period.
Drawback 2: Risk and the Time Value of Money
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. 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.
- 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.
- While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment.
- A second disadvantage of using the payback period method is that there is not a clearly defined acceptance or rejection criterion.
- 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.
- Cash outflows include any fees or charges that are subtracted from the balance.
Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business. While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment. That’s what the payback period calculation shows, adding up your yearly savings until the $400,000 what if analysis vs sensitivity analysis investment has been recouped. In order to purchase the embroidery machine, Sam’s Sporting Goods must spend $16,000. During the first year, Sam’s expects to see a $2,000 benefit from purchasing the machine, but this means that after one year, the company will have spent $14,000 more than it has made from the project.
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. Before you invest thousands in any asset, be sure you calculate your payback period. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.
Payback period
First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period with varying break-even points due to the varying flows of cash each project generates. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects.
Advantages and Disadvantages of the Payback Period
However, Projects B and C end after year 5, while Project D has a large cash flow that occurs in year 6, which is excluded from the analysis. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. The payback period method provides a simple calculation that the managers at Sam’s Sporting Goods can use to evaluate whether to invest in the embroidery machine.
Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment. In most cases, a longer payback period also means a less lucrative investment as well. A shorter period means they can get their cash back sooner and invest it into something else. 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?
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. However, we know that money has a time value, and receiving $6,000 in year 1 (as occurs in Project C) is preferable to receiving $6,000 in year 5 (as in Projects B and D). From what we learned about the time value of money, Projects B and C are not identical projects. The payback period method breaks the important finance rule of not adding or comparing cash flows that occur in different time periods.
Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period. Since the payback period focuses on short term profitability, a valuable project may be overlooked if the payback period is the only consideration. Payback period intuitively measures how long something takes to “pay for itself.” All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below.
The discounted payback period determines the payback period using the time value of money. Management uses the cash payback period equation to see how quickly they will get the company’s money back from an investment—the quicker the better. In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks. It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster.
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. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded. We’ll explain what the payback period is and provide you with the formula for calculating it. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below.
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. Although it is simple to calculate, the payback period method has several shortcomings. Suppose that in addition to the embroidery machine, Sam’s is considering several other projects. For both of these projects, Sam’s estimates that it will take five years for cash inflows to add up to $16,000. The payback period method does not differentiate between these two projects. According to payback method, the project that promises a quick recovery of initial investment is considered desirable.
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