How to calculate the payback period Definition & Formula

payback period formula

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 Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment.

Calculating the Discounted Payback Period

payback period formula

So, in this particular example, the business should break even, ceteris paribus, in five years. Any income generated after that, assuming nothing else changes, will be considered to be profit. In this guide, we will discuss the most important things you need to know about the payback period in the world of finance, including what it is and how to calculate it. Depending on the nature of the investment, there will usually be a considerable amount of time that passes before the business is able to reach its breakeven point. When businesses choose to make an investment, they will do so with the goal of eventually making a profit. This means that, at some point in time, they will end up with more money than they have in the status quo.

  • Any income generated after that, assuming nothing else changes, will be considered to be profit.
  • The second project will take less time to pay back, and the company’s earnings potential is greater.
  • Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets.
  • Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project’s process.
  • According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X.

Key Issues in Making Investment Decisions

By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000. It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments.

Payback Period (Payback Method)

  • Conversely, if proceeds after the period have a dramatic uptick and move into the green, then the investment is a wise decision.
  • The following hypothetical example will provide better clarification regarding comparing investments.
  • Unlike the IRR, the MIRR uses the reinvestment rate for positive cash flows and the financing rate for the initial outflows.
  • A regularly used metric by managers to evaluate the viability of investments, the internal rate of return, or IRR, is the rate of return that makes a project worthwhile investing in.
  • Norris pumped in a fastest lap, gaining a chunk of time through the wettest part of the circuit at Turns 1 and 2, and was told to “give it everything” before pitting.
  • Let’s contrast the Payback Period against other capital budgeting metrics, providing a robust comparison to guide business leaders, financial managers, and investors towards more strategic investment decisions.

This method provides a more realistic payback period by considering the diminished value of future cash flows. Even cash flows produce the same amount of cash annually over a period of time, for example, $25,000 annually for 5 years. On the other hand, uneven cash flows generate various annual cash streams over a period of time. It is used by small or medium companies that make relatively small investments with constant annual cash flows.

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. For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year. The discounted cash flows are then compared to the initial cost – the point when the discounted cash flows equal the investment outflow is when the investment or project breaks even.

  • For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure.
  • The reinvestment rate refers to the company’s weighted average cost of capital or WACC.
  • Given Verstappen was already concerned about his suspension stiffness, saying he couldn’t run over the curbs, to now have Norris right behind him on similarly-aged tires was pressure.
  • Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM).
  • For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month.

Payback Period and Capital Budgeting

For example, imagine a company invests £200,000 in new manufacturing equipment which results in a positive cash flow of £50,000 per year. The reinvestment rate refers to the company’s weighted average cost of capital or WACC. The WACC is the function of the weighted average of the cost of equity and the cost of debt. Conversely, if the IRR falls below the required rate of return that the company or the investor seeks, then other more economically viable alternatives should be considered.

payback period formula

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, 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. The payback period is the amount of time it would take for an investor to recover a project’s initial cost.

How to Calculate Payback Period

payback period formula

Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes. The opposite stands for investments with longer payback periods – they’re less useful and less likely to be undertaken.

The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in. 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. The payback period with the shortest payback time is generally regarded as the best one. This is an especially good rule to follow when you must choose between one or more projects or investments.

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