In order to help you advance your career, CFI has compiled many resources to assist you along the path. Now that you have all the information, it’s time to set up your Excel spreadsheet. In the first row, create headers for the different pieces of information you are going to use in your calculation.

This time-based measurement is particularly important to management for analyzing risk. The payback period calculation doesn’t account for the time value of money or consider cash inflows beyond the payback period, which are still relevant for overall profitability. Therefore, businesses need to use other financial metrics in conjunction with payback period to make informed investment decisions. The first step in calculating the payback period is to gather some critical information.

Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years. When cash flows are NOT uniform over the use full life of the asset, then the cumulative cash flow from operations must be calculated for each year. In this case, the payback period shall be the corresponding period when cumulative cash flows are equal to the initial cash outlay. For example, a firm may decide to invest in an asset with an initial cost of $1 million.

The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. Management uses the payback period calculation to decide what investments or projects to pursue. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

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As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. 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. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.

• This method provides a more realistic payback period by considering the diminished value of future cash flows.
• Thus, the averaging method reveals a payback of 2.5 years, while the subtraction method shows a payback of 4.0 years.
• Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks.

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This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them. The payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. 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. For example, if it takes calculate payback period five years to recover the cost of an investment, the payback period is five years. Average cash flows represent the money going into and out of the investment.

• However, it’s important to consider not just how quickly you get your money back but also the overall profitability and long-term benefits of the investment.
• The first step in calculating the payback period is to gather some critical information.
• Both the above are financial metrics used for analysis and evaluation of projects and investment opportunities.
• All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment.
• 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.

Multiply this percentage by 365 and you will arrive at the number of days it will take for the project or investment to earn enough cash to pay for itself. Both the above are financial metrics used for analysis and evaluation of projects and investment opportunities. When cash flows are uniform over the useful life of the asset, then the calculation is made through the following payback period equation. Payback period can be defined as period of time required to recover its initial cost and expenses and cost of investment done for project to reach at time where there is no loss no profit i.e. breakeven point. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time.

Analysis

Thus, maximizing the number of investments using the same amount of cash. A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. Let us see an example of how to calculate the payback period equation when cash flows are uniform over using the full life of the asset. 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.

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. The decision rule using the payback period is to minimize the time taken for the return on investment. The Payback Period shows how long it takes for a business to recoup an investment.

Over the next five years, the firm receives positive cash flows that diminish over time. As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. Tools such as net present value (NPV) and internal rate of return (IRR) offer a more comprehensive view of investment profitability, but they are more complex to calculate.

Comparing Payback Periods for Different Investments

It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. Payback period is a financial or capital budgeting method that calculates the number of days required for an investment to produce cash flows equal to the original investment cost. In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven.

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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.

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. The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost. The discounted payback period extends the concept of the payback period by considering the time value of money. Here, future cash inflows are discounted using a particular rate, reflecting their present value.

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. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. 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. Most of what happens in corporate finance involves capital budgeting—especially when it comes to the values of investments. Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment.

Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. 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.