payback period formula

Multiple internal rates of return occur when dealing with non-normal cash flows, also called unconventional or irregular cash flows. If the IRR of an investment is higher than the company’s or the investor’s required rate of return, this sends a strong signal that it is worth undertaking. Just like the basic payback period, its modified counterpart calculates the time required to retrieve the invested funds. The payback period is a valuable and simple analysis tool that can facilitate the comparison of alternative investments.

How to calculate payback period

It is a measure of how long it takes for a company to recover its initial investment in a project. It is one of the simplest capital budgeting techniques and, for this reason, is commonly used to evaluate and compare capital projects. The net present value, or NPV, discounts future cash flows to their present value using an appropriate discount rate and the number of time periods during which cash flows will be generated.

Payback Period Vs. Other Capital Budgeting Metrics

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. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. As mentioned above, the payback period is the amount of time it takes to recover the initial costs of an investment.

Example 1: Even Cash Flows

The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. 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. Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money.

  • Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached.
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  • For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years.
  • According to payback method, the project that promises a quick recovery of initial investment is considered desirable.
  • 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.

This is calculated by dividing the initial investment by its annual return, as shown in the formula below. Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business. The payback period is the time it will take for your business to recoup invested funds.

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payback period formula

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. If we assume the cash flows occur evenly during the 4th year, the payback is 65,000/75,000ths through the 4th year, noting that $65,000 is the negative balance at the end of Year 3, and $75,000 is generated in Year 4. It is an easy-to-use and understood investment appraisal technique, used in corporate finance, that provides the time period over which an investment will be returned. It has limited practicality in investment decision-making and shouldn’t be used in isolation.

payback period formula

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