payback period formula

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. Understanding the time value of money (TVM) is key for anyone who needs to make important financial decisions. A discounted cash flow analysis is a method to value an investment based on expected future cash flows, adjusting for the time value of money.

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

But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. The call seemed strange, given how quickly the track was drying and how vital each additional lap on slicks over the intermediates would be. McLaren’s thinking was that a worn intermediate at the end of a stint would still be better than the first lap or two on a cold, new slick. 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. He had a chance to at least leapfrog Russell by getting the overcut, and unexpectedly managed to briefly pull clear of Verstappen’s Red Bull as he exited the pits.

  • Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.
  • It also has the function of helping with managing investment risk—the shorter the time it takes to recover the initial investment, the less risky the investment.
  • Alternative measures of “return” preferred by economists are net present value and internal rate of return.
  • It is expressed as a percentage and is a function of the initial investment capital and the final value, which includes dividends and interest.
  • The Ascent, a Motley Fool service, does not cover all offers on the market.

Alternatives to the payback period calculation

Alternatively, the discounted payback period reflects the amount of time necessary to break even in a project, based not only on what cash flows occur but when they occur and the prevailing rate of return in the market. But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. 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.

How to calculate payback period

The reason for this is because the longer cash is tied up, the less chance there is for you to invest elsewhere, and grow as a business. Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash. One of the biggest advantages of the payback period method is its simplicity. The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time.

  • For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year.
  • Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.
  • Every year, your money will depreciate by a certain percentage, called the discount rate.
  • 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.
  • You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one.

Payback Period (Payback Method)

payback period formula

Conversely, a good investment is one that takes less time to generate returns or is of a relatively short length. Unlike the break-even point, which uses the number of units sold to offset the costs, the payback is the length of time required for an investment to pay back for itself. Cathy currently owns a small manufacturing business that produces 5,000 cashmere scarfs each year. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year. Using the new machine is expected to produce an additional $150,000 in cash flow each year that it’s in use. This means the amount of time it would take to recoup your initial investment would be more than six years.

Scientific Decision Making

payback period formula

The term cash flow signifies the amount of money that an investment generates or consumes over a period of time. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects. For lower return projects, management will only accept the project if the risk is low which means payback period must be short. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex.

Pros of payback period analysis

This means that the initial investment will be $10,000 and that the annual cash flow would be $2,000. In summary, the payback period and its variant, the discounted payback period, serve as useful initial screenings for investment projects, focusing on liquidity risk. 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. Therefore, the payback period for this project is 5 years, which means that it will take 5 years to recover the initial $100,000 investment from the annual cash inflows of $20,000. Payback period is a fundamental investment appraisal technique in corporate financial management.

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. Using a discounted cash flow calculator and acknowledging your personal discount rate can help you make the right financial decision. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value.

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