Payback Period: Definition, Formula, and Calculation

The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments. The main reason for this is it doesn’t take into consideration the time value of money.

The discounted payback period is a simple metric to determine if an investment will be sufficiently profitable to justify the initial cost. It uses the predicted returns from the investment, but also takes into consideration the diminishing value of future returns. The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even.

1. For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month.
2. 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.
3. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period.
4. The payback period is the time it will take for your business to recoup invested funds.
5. Jim estimates that the new buffing wheel will save 10 labor hours a week.

Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. 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. 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. 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.

Maybe you’d like to purchase a new building, but you’re unsure if the savings will be worth the investment. Calculating the payback period for the potential investment is essential. The payback period is the time it will take for your business to recoup invested funds. For instance, if your business was considering upgrading assembly line equipment, you would calculate the payback period to determine how long it would take to recoup the funds used to purchase the equipment. When cash flows are uniform over the useful life of the asset, then the calculation is made through the following payback period equation. Every investor, be it individual or corporate will want to assess how long it will take for them to get back the initial capital.

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As you can see, using this payback period calculator you a percentage as an answer. 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. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering.

Analysis

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. Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment. In most cases, a longer payback period also means a less lucrative investment as well.

When Would a Company Use the Payback Period for Capital Budgeting?

Jim estimates that the new buffing wheel will save 10 labor hours a week. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. This means the amount of time it would take to recoup your initial investment would be more than six years. Both the above are financial metrics used for analysis and evaluation of projects and investment opportunities.

For example, three projects can have the same payback period with varying break-even points due to the varying flows of cash each project generates. 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. 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 laid out for the project. 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. The breakeven point is the price or value that an investment or project must rise to cover the initial costs salary or draw or outlay.

For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month. 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. A higher payback period means it will take longer for a company to cover its initial investment. 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. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor. 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.

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. While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment.

The above article notes that Tesla’s Powerwall is not economically viable for most people. As per the assumptions used in this article, Powerwall’s payback ranged from 17 years to 26 years. Considering Tesla’s warranty is only limited to 10 years, the payback period higher than 10 years is not idea. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach.

Cathy currently owns a small manufacturing business that produces 5,000 cashmere scarfs each year. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year. Using the new machine is expected to produce an additional $150,000 in cash flow each year selling expense budget that it’s in use.

Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows. At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The standard payback period is simply the amount of time an investment takes to recoup the initial cost.

A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project. Longer payback periods are not only more risky than shorter ones, they are also more uncertain.