What is Payback Period?
The payback period is a fundamental capital budgeting tool and one of the simplest investment appraisal techniques.
Payback period refers to the amount of time required for your investment to pay back or in other words it is the amount of time required for cash inflows generated by a project to offset its initial cash outflow. The rule is ‘Early is better’ means a project that generates a quick return is less risky than one that generates the same return over a longer period.
How to Calculate Payback Period
There are two ways to calculate the payback period, which are described below.
- Payback Period
- Discounted Payback Period
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Payback Period
The formula to calculate payback period is:
Payback Period = Initial Investment / Annual Net Cash Flow
The payback period is calculated by dividing the initial cost of the investment by the annual net cash flow generated by the investment.
Example 1
Company A is planning to undertake a project requiring initial investment of $154 million. The project is expected to generate $35 million per year equally for 7 years.
Payback Period = Initial Investment ÷ Annual Cash Flow
= $154M ÷ $35M = 4.4 years
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Discounted Payback Period
The missing factor in simple payback period formula is that it is missing ‘time value of money’ so to overcome this we use a modified version of the payback period that accounts for the time value of money.
The discounted payback period is the number of years after which the cumulative discounted cash inflows cover the initial investment. To calculate 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 and finally we will subtract the discounted cash flows from the initial investment to obtain the discounted payback period.
Payback Period vs. Discounted Payback Period Method
The formula for both the methods is virtually identical but as discounted method takes care of the missing factor of simple payback which is ‘time value of money’ so in later we use discounted cash flows. These two methods may not return the same result due to the discounting of cash flows.
Other Ways to Calculator Payback Period
Simplest way to calculate payback period is by using any calculator like:
https://www.calculator.net/payback-period-calculator.html
https://cleartax.in/s/payback-period-calculator
What is a Good Payback Period?
All investors wish to recover their initial investment quickly so the shorter the payback period is always considered good. In shorter Payback Period the earlier the cash inflows from a potential project can offset the initial investment. Generally, a shorter payback period makes an investment more appealing and attractive.
Benefits of Payback Period
It helps with comparing and choosing investment options and considered as a financial planning tool as it is:
- Easy to understand
- Simple to calculate
- Measures investment risk
Recommended Reading: https://accountingblogger.com/internal-rate-of-return-irr/
Payback period vs Break-even point
The break-even point tells us the amount of revenue required to achieve a no-profit, no-loss scenario. Whereas the payback period tells us how much time it takes for a company to recover its original investment.
Recommended Reading: https://accountingblogger.com/break-even-point/
The Takeaway
The payback period is used to make investment decisions. Investors, financial experts, and businesses normally find themselves in situations where they must choose between projects. Payback is frequently used as a first screening method for an investment. Payback period analysis is a method used to determine the relative time value of a project. It measures the time that a project will take to return its initial investment. The payback period is the simplest of all financial appraisal methods and is computed by dividing the investment amount by the cash flows. The simple payback period ignores time value of money and to overcome this we use a modified version of the payback period named ‘Discounted Payback Period’ that accounts for the time value of money. Payback method ignores cash flows after the payback period. The shortest payback period is generally considered to be the most acceptable.
ABOUT THE AUTHOR
Humayun Atif | CMA, CPA, CA (FIN), MS-IT, CA Articles from Big 4, Certified Forensic Accountant (USA), Six Sigma & Oracle Certified.
Atif is passionate about Business, Tech, and the written word. He is the author of the book ‘IFRS Made Easy’. He is a Tax and IFRS coach and the founder of accountingblogger.com
