Payback period: Learn How to Use & Calculate It
Evaluating payback period helps companies recognize different investment opportunities and determine which product or project is most likely to recoup their cash in the shortest time. A fast return may not be a priority for every business in every case, but it’s a crucial consideration all the same. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. A payback period refers to the time it takes to earn back the cost of an investment.
How to Calculate the Payback Period in Excel
Hence, the best use case of IRR is when the investment being analyzed does not generate a lot of intermediate cash flows. 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. Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased. 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. In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs).
Decision Rule
The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. 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. The present value of the discounted future cash flows is compared to the initial capital outlay. If the result returns a positive number over the time period, then the investment is worth pursuing.
The Time Value of Money (or Net Present value)
The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years. However, the payback period calculation poses a noteworthy problem as it does not take into account the time value of money.
Payback Period Explained: Definitions, Formulas and Examples
It assists in evaluating and considering the duration required to recover the initial costs and investment linked to a particular investment. This financial metric is particularly valuable for making quick decisions about investment opportunities. Therefore, it is beneficial to calculate the payback period before deciding on an investment venture. Company C is planning to undertake a project requiring initial investment of $105 million.
- There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5.
- For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period.
- As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be.
Conversely, if proceeds after the period have a dramatic uptick and move into the green, then the investment is a wise decision. It doesn’t represent these two scenarios – profitability or lack thereof. The break-even point, a highly used concept in economics and business, simply means that there are no losses or gains, or in other words, that total costs equal total revenue for a specific venture.
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. As you can see in the example below, a DCF model is used to graph the payback period (middle graph below).
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. There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV (net present value). While both the payback period and the break-even point are essential measures of financial performance, they are calculated and used in different ways. The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven.
For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. The payback period is the amount of time it takes for an investment to generate enough cash flow to recover its initial cost. Capital budgeting has always been appreciated as a critical operation in corporate finance.
As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects.
It is typically implied that money in the present-day holds more value than the same amount of money in the future. In addition, the IRR assumes that the generated cash flows are reinvested at the generated rate. This can cause inaccuracies if the received philosophy of language and accounting cash flows can’t be reinvested at, let’s say, at 6% when the IRR is 14%. 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.
These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program. When it comes to the payback period, https://www.adprun.net/ a lower number is generally considered better than a higher number. This is because a lower payback period means that the investment will pay for itself more quickly, which is generally seen as a positive outcome.
It provides a straightforward and easy way for calculating even and uneven cash flows. The simplest way to differentiate between even and uneven cash flows is by evoking the concept of an annuity. The payback period is a valuable and simple analysis tool that can facilitate the comparison of alternative investments. The following hypothetical example will provide better clarification regarding comparing investments.
If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can’t be applied. This formula ignores values that arise after the payback period has been reached. The profitability index, or PI, indicates the profitability and attractiveness of the investment in a project. The PI is the expressed ratio of the present value of discounted future cash flows to the initial invested capital. 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. The out put of using the payback tool is expressed in years or a fraction of years.
