Payback method formula, example, explanation, advantages, disadvantages

Using the payback period to assess risk is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR). This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment. Another option is to use the discounted payback period formula instead, which adds time value of money into the equation. In summary, the Payback Period, ROI, and NPV are distinct metrics serving different purposes.

• So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100).
• The payback period is commonly used by investors, financial professionals, and corporations to calculate investment returns.
• The Payback Period shows how long it takes for a business to recoup an investment.
• Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method.
• The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay.

Due to the increase in discounting over time due to the effect of compounding, positive payback returns may turn into negative ones after being discounted. Supposing the cost of a project turns out to be twenty thousand dollars, the profit of a mere three thousand dollars with the depreciation of ten percent and a tax slab of thirty percent. Financial investment is the simple exchange of asset ownership through the buying and selling of equity or the transactions of bonds, shares, and stocks in the open market.

The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. With its emphasis on liquidity, the payback period is particularly relevant for investors and businesses concerned with short-term financial goals. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.

What Are Some of the Downsides of Using the Payback Period?

These investments are less risky because the company gets its money back quicker and can reinvest it into a new piece of equipment. It aligns well with risk preferences, particularly in industries or sectors where market dynamics and uncertainties can change rapidly. Decision-makers may favor projects with shorter payback periods as they seek to mitigate exposure to prolonged risks.

Not Applicable for Projects with Continuous Cash Flows

This method provides a more realistic payback period by considering the diminished value of future cash flows. Here, if the payback period is longer, then the project does not have so much benefit. However, a shorter period will be more acceptable since the cost of the investment can be recovered within a short time. It is considered to be more economically efficient and its sustainability is considered to be more. Many managers and investors prefer to use NPV as a tool for making investment decisions for this reason. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period.

#2: What’s the Difference Between the Payback Period and the Breakeven Point?

A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. Take an example where a project requires an initial investment of $150,000. In its first three years, the project is expected to return net cash of $10,000, $25,000, and $50,000.

Two projects with the same payback period may have different risk profiles, making it necessary for decision-makers to consider additional risk assessment methods when making investment decisions. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. 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.

It aids decision-makers in aligning their investment decisions with the timing of cash inflows. It is essentially a measure of time, representing how many years it will take for the cumulative cash inflows to equal the initial investment. The formula divides the initial investment by the annual cash inflow to determine how many years it will take to recoup the initial capital. According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years.

Uses of Payback Period in Corporate Finance

A payback period, on the other hand, is the time it takes to recover the cost of an investment. 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.

That is why shorter payback periods are almost always preferred over longer ones. The faster the company can receive its cash, the more acceptable the investment becomes. Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. No, the payback period does not take into account the time value of money.

• Let’s assume that you’re debating whether it makes sense to attend a 6-month coding boot camp that costs $30,000 to get a certificate in web development.
• Managerial accountants really have no idea what their investment is going to do in the future.
• A shorter payback period reduces the company risk of inaccurate future projections of investment cash flow.
• Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment.

May Favor Low-Quality Projects

In this calculator, you can estimate the payback period by entering the initial investment amount, the net cash flow per period, and the number of periods before investment recovery. Despite its simplicity and usefulness in initial investment screening, the payback period should not be the sole criterion for investment decisions. It is most effective when used alongside other metrics to provide a comprehensive evaluation of a project’s financial attractiveness.

But if you are among the crowds of people who know little to nothing about payback periods or finance, this article is for you. It is not suitable for projects with continuous cash flows, such as those in which revenues continue beyond the initial investment recovery. In such cases, alternative metrics like the net present value (NPV) or internal rate of return (IRR) may provide a more comprehensive assessment. 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. 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 vs. Other Investment Metrics

If they invest, they would be making their money back 0.25 years early, which means that this would be a financially sound investment for the company. We can apply the values to our variables and calculate the projected payback period for the new series. But, as we know, cash flow is not always even from period to period, especially when we are talking about the income from an investment. We can then begin calculating your cash flow each year to determine when you’ll expect to break even.

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 it’s laid out for the project. A short payback period may be more attractive than a longer-term investment that has a higher NPV if short-term cash flows are a concern. It doesn’t account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time.

When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare pay back period meaning an investment to «doing nothing,» payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. 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. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment.

In simpler terms, it indicates the period required for the cash inflows generated by an investment to equal the initial cash outlay. This metric is widely used in financial analysis to assess the risk and profitability of a particular investment, providing valuable insights into the investment’s breakeven point. Management uses the payback period calculation to decide what investments or projects to pursue. The discounted payback period determines the payback period using the time value of money. The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money.

For example, a homeowner might decide a payback period of seven years on solar panels is good, while a company facing a payback period of seven years for a new software system deems it unacceptable. The subtraction method of the payback formula can help you assess an investment when cash flow is likely to vary from year to year. Based on this, the relative cost of the investment is $1,750, which we’ll plug into the payback period calculation. Financial models are utilized in this case, or the payback period method as both are reliable tools for project appraisal. It may favor projects with lower upfront costs, even if they generate lower returns. This bias can lead to the selection of projects that may not be the most economically viable in the long term.