Payback method formula, example, explanation, advantages, disadvantages
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. The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project.
- For example, if it takes five years to recover the cost of an investment, the payback period is five years.
- 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.
- Financial modeling best practices require calculations to be transparent and easily auditable.
- It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
- An implicit assumption in the use of payback period is that returns to the investment continue after the payback period.
Based solely on the https://www.wave-accounting.net/ method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.
There are two steps involved in calculating the discounted payback period. First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years.
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The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back. Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number. Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV.
Payback period
According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods. The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years.
Is a Higher Payback Period Better Than a Lower Payback Period?
However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. The payback period with the shortest payback time is generally regarded as the best one. This is an especially good rule to follow when you must choose between one or more projects or investments. 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 purchase of machine would be desirable if it promises a payback period of 5 years or less. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period. Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow.
Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting. Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes.
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000. Cumulative net cash flow is the sum of inflows to date, minus the initial outflow. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
The table indicates that the real how to categorize credit card payment in wave accounting 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. 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.
However, this method does not take into account several key factors including the time value of money, any risk involved with the investment or financing. For this reason, it is suggested that corporations use this method in conjunction with others to help make sound decisions about their investments. Most of what happens in corporate finance involves capital budgeting — especially when it comes to the values of investments.
It is easy to calculate and is often referred to as the “back of the envelope” calculation. Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.
Payback Period: Definition, Formula & Examples
Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. In such situations, we will first take the difference between the year-end cash flow and the initial cost left to reduce. Next, we divide the number by the year-end cash flow in order to get the percentage of the time period left over after the project has been paid back. One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year. In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year.
In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues. When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment.
The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period.
The payback method should not be used as the sole criterion for approval of a capital investment. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. The discounted payback period is the number of years it takes to pay back the initial investment after discounting cash flows. In Excel, create a cell for the discounted rate and columns for the year, cash flows, the present value of the cash flows, and the cumulative cash flow balance. Input the known values (year, cash flows, and discount rate) in their respective cells. Use Excel’s present value formula to calculate the present value of cash flows.
