payback period formula

In conditions of uncertainty, the shorter payback means good cushioning and risk mitigation. In the first case, the period over which the capital is paid back for project A is 10 years, while for project B it is 5 years. Payback period is a vital metric for evaluating the time taken for an investment to break even. For example, if the building was purchased mid-year, the first year’s cash flow would be $36,000, while subsequent years would be $72,000. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created to help people learn accounting & finance, pass the CPA exam, and start their career.

How to Calculate the Payback Period in Excel

  • When all else is equal, a business will typically seek investments that offer a shorter payback period, though there are plenty of situations where a longer payback period will make the most sense for a business.
  • She is currently a senior quantitative analyst and has published two books on cost modeling.
  • The situation gets a bit more complicated if you’d like to consider the time value of money formula (see time value of money calculator).
  • Financial modeling best practices require calculations to be transparent and easily auditable.

If the result returns a positive number over the time period, then the investment is worth pursuing. The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even. The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.

Comparing Payback Period with Other Methods

First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more.

What Is the Formula for Payback Period in Excel?

The metric is used to evaluate the feasibility and profitability of a given project. Longer payback periods are not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future. For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs.

  • One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.
  • The benefits it has can be layered and complimented by the other capital budgeting measures for assessing a project’s risk, profitability, attractiveness, and viability.
  • The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management.
  • Rohan has a focus in particular on consumer and business services transactions and operational growth.
  • It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments.

On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator. The study of cash flow provides a general indication of solvency; generally, having adequate cash reserves is a positive sign of financial health for an individual or organization. Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment. The payback period also facilitates side-by-side analysis of two competing projects.

Advantages and disadvantages of payback method:

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. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital.

payback period formula

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. The index is a good indicator of whether a project creates or destroys company value. The basic payback period, as presented above, and its benefits and limitations give an overall idea of the concept. Evaluating the risk is especially important when the liquidity factor is a significant consideration.

payback period formula

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