Payback period: Learn How to Use & Calculate It

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. By the end of Year 3 the cumulative cash flow is still negative at £-200,000.

• 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 quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
• It should be used with, but not limited to, the mentioned cash flow metrics, NPV and RoR, to build a more exhaustive picture of the viability of a project, its downside risks, and trade-offs.
• The payback period is an essential assessment during the calculation of return from a particular project.
• However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year.
• Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking.

Are you still undecided about investing in new machinery for your manufacturing business? Perhaps you’re torn between two investments and want to know which one can be recouped faster? Maybe you’d like to purchase a new building, but you’re unsure if the savings will be worth the investment. Knowing the payback period is helpful if there’s a risk of a project ending in the future. For example, if a company might lose a lease or a contract, the sooner they can recoup any investments they’re making into their business the less risk they have of losing that capital.

Advantages and disadvantages of payback period

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered. Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process.

• In other words, it is the amount of time taken for an investment to reach its breakeven point.
• The cumulative net cash flow looks at what you get when you combine all positive cash flows and negative cash flows.
• The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows.
• You’ll look at the cumulative cash flow to determine between which two years the investment will recuperate.

In general, a shorter payback period is considered better, as it indicates that the investment will generate a positive return more quickly. However, what is considered a “good” payback period will depend on the goals of the investor and the nature of the investment. For example, a long-term investment with a high degree of risk may have a longer payback period but could still be a good investment if it has the potential for substantial returns over time.

Example of the Payback Method

For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. People and corporations mainly invest their money to get paid back, which is why the payback period payback equation is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows.

In other words, money that someone has right now can begin earning interest. Money is always worth more the sooner it can be secured because it will have more time to earn interest. Therefore, businesses should also examine the lost opportunity cost and the interest rate on investments when it comes to earning interest on funds. This calculation can help organizations better evaluate the best investments for their businesses. Generally, those with shorter payback periods are better than those with long payback periods.

Years to Break-Even Formula

The payback period can help investors decide between different investments that may have a lot of similarities, as they’ll often want to choose the one that will pay back in the shortest amount of time. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. 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. The out put of using the payback tool is expressed in years or a fraction of years. It is a function of the initial invested capital and the average annual net cash flows generated by the investment.

This is the amount of money that the business had to pay when getting started on their project. Many business owners find that the payback period calculator works best when used for a quick understanding of investments or as a single tool in a full toolbox of evaluations for determining a worthy investment. One of the major characteristics of the payback period is that it ignores the value of money over time.