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. The discounted payback period considers the time value of money, whereas the conventional payback period does not. 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. The payback period is when it takes to pay back the money invested in an investment. It indicates how long an asset, such as a machine or plant, will take to make enough profit to repay the original cost.

Payback Formula (Subtraction Method)

This will help give them some parameters to work with when making investment decisions. If the calculated payback period is less than the desired period, this may be a safer investment. This still has the limitation of not considering cash flows after the discounted payback period.

• Simply put, it is the length of time an investment reaches a breakeven point.
• The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it.
• Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account.
• Company C is planning to undertake a project requiring initial investment of $105 million.
• When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex.
• This still has the limitation of not considering cash flows after the discounted payback period.
• It is one of the simplest capital budgeting techniques and, for this reason, is commonly used to evaluate and compare capital projects.

How to Calculate Payback Period

• The payback period can apply to personal investments such as solar panels or property maintenance, or investments in equipment or other assets that a company might consider acquiring.
• Prior to calculating the payback period of a particular investment, one might consider what their maximum payback period would be to move forward with the investment.
• Since the concept helps compute payback period with the breakeven point, the investor can easily plan their financial strategies further and make more decisions regarding the next step.
• Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value.
• The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven.

One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period. A lower payback period is preferable as it reduces risk and enhances investment effectiveness. A reasonable payback period also generates a faster return on investment; thus, it is CARES Act an essential determinant of financial decisions.

Personal Loans

• 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.
• Using the subtraction method, subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved.
• The discounted payback period considers the time value of money, whereas the conventional payback period does not.
• The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows.
• The investing platform lets you research and track your favorite stocks and ETFs.
• A higher payback period means it will take longer for a company to cover its initial investment.

The payback period refers to how long it takes to reach that breakeven. When cash flows are uniform over the useful life of the asset, then the calculation is made through the following payback period equation. 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. 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.

Example 2: Uneven Cash Flows

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Years to Break-Even Formula

For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs. That’s why a shorter payback period is always preferred over a longer one. The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes.

In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account. The time value of money is the idea that cash will be worth more in the future than it is worth today, due to the amount of interest bookkeeping and payroll services that it can generate.