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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. Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project’s process. For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years.

The breakeven point is a specific price or value that an investment or project must reach so that the initial cost of that investment or project is completely returned. Whereas the payback period refers to the time it takes to reach the breakeven point. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows.

When cash flows are uniform over the useful life of the asset, then the calculation is made through the following payback period equation. 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. Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached.

Assessing Risk

Since the concept helps compute payback period with the breakeven point, the investor can easily plan their financial strategies further and make more decisions regarding the next step. It is calculated by dividing the investment made by the cash flow received every year. This is a valuable metric for fund managers and analysts who use it to determine the feasibility of an investment. However, it is to be noted that the method does not take into account time value of money. Investments with longer payback periods are most risky than ones with shorter periods because there is no way to know how the future will pan out. A manager is more likely to purchase a machine that should pay for it self in 6 months, than something that will tie up company funds for 3 years.

We explain its formula, how to calculate, example, advantages, disadvantages & differences with ROI. In case the sum does not match, then the period in which it lies should be identified. After that, we need to calculate the fraction of the year that is needed to complete the payback. We’ll now move to a modeling exercise, which you can access by filling out the form below.

Formula

The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project. Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects.

CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.

1. The breakeven point is the level at which the costs of production equal the revenue for a product or service.
2. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment.
3. As the equation above shows, the payback period calculation is a simple one.
4. Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM).
5. Let’s say the net cash flow amount is expected to be higher, say $240,000 annually.
6. A large purchase like a machine would be a capital expense, the cost of which is allocated for in a company’s accounting over many years.

Payback Period Formula

The longer an asset takes to pay back its investment, the higher the risk a company is assuming. The shortest payback period is generally considered to be the most acceptable. This is a particularly good rule to follow when a company is deciding between one or more projects or investments.

Let us understand the concept of how to calculate payback period with the help of some suitable examples. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period.

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. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance.

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. The decision rule using the payback period is to minimize the time taken for the return on investment. The discounted payback period determines the payback period using the time value of money. The equation doesn’t factor in what’s happening in the rest of the company. Let’s say the new machine, by itself, is working wonderfully and operating at peak capacity. But perhaps it’s a huge draw on the plant’s power, and its affecting other systems.

Cash outflows include any fees or charges that are subtracted from the balance. Let’s say the net cash flow amount is expected to be higher, say $240,000 annually. Both the above are financial metrics used for analysis and evaluation of projects and investment opportunities. This 20% represents the rate of return the project or investment gives should taxes on stock influence your decision to buy or sell every year.

One way corporate financial analysts do this is with the payback period. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter the 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. 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.

Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of capital commitment definition the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded.