Payback Period: Formula and Calculation Examples

GoCardless helps businesses automate collection of both regular and one-off payments, while saving time and reducing costs. On the other hand, payback period calculations can be so quick and easy that they’re overly simplistic. The payback period calculation is straightforward, and it’s easy to do in Microsoft Excel. •   The payback period is the estimated amount of time it will take to recoup an investment or to break even.

• Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater.
• For example, a firm may decide to invest in an asset with an initial cost of $1 million.
• Investors might also choose to add depreciation and taxes into the equation, to account for any lost value of an investment over time.
• Understanding the limitations and how to interpret the results correctly is crucial for making informed decisions.
• The second project will take less time to pay back, and the company's earnings potential is greater.

How to Calculate NPV in Excel

• 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.
• This calculation is useful for risk reduction analysis, since a project that generates a quick return is less risky than one that generates the same return over a longer period of time.
• In this case, setting up a table in Excel will help evaluate and estimate the payback period.
• The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it.
• Inflows are any items that go into the investment, such as deposits, dividends, or earnings.
• Let’s assume that a company invests cash of $400,000 in more efficient equipment.
• Thus, maximizing the number of investments using the same amount of cash.

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#2: What’s the Difference Between the Payback Period and the Breakeven Point?

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. minimum level of stock explanation formula example These headers should include Initial Investment, Cash Inflow, Cumulative Cash Flow, and Payback Period. Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.

The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project. However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. For example, a firm may decide to invest in an asset with an initial cost of $1 million. 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.

Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash. Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes. The opposite stands for investments with longer payback periods - they’re less useful and less likely to be undertaken. Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method.

That’s why a shorter payback period is always preferred over a longer one. The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes. The payback period is a simple measure of how long it takes for a company to recover its initial investment in a project from the project’s expected future cash inflows. As such, it should not be used alone as an investment appraisal technique – other methods should be used such as ROI, NPV or IRR. In its simplest form, the payback period is calculated by dividing the initial investment by the annual cash inflow. Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow.

Is a Higher Payback Period Better Than a Lower Payback Period?

When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). Since the second option has a shorter payback period, this may be a better choice for the company.

The payback period is the amount of time it will take to recoup the initial cost of an investment, or to reach its break-even point. 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 discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows.

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In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks. It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster. Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division. 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. 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.

Benefits of Using the Payback Period

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. Microsoft Excel offers a wide range of tools and functions that make financial calculations easier and more accurate. With a little bit of practice, you can master the payback period calculation and use it to make informed investment decisions that will benefit your business in the long run.

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 the best preferred stocks endeavor. The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.

Payback Period and Capital Budgeting

I'm dedicated to helping others master Microsoft Excel and constantly exploring new ways to make learning accessible to everyone. On the other hand, Jim could purchase the sand blaster and save $100 a week from without having to outsource his sand blasting. If you have any questions or need help getting started, SoFi has a team of professional financial advisors available to help you reach your personal financial goals. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. In case the sum does not match, then the period in which it lies should be identified.

Example of Payback Period Using the Subtraction Method

Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost. A payback period, on the other hand, is the time it takes to recover the cost of an investment. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex.

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According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. 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. The purchase of machine would be desirable if it promises a payback period of 5 years or less. 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. The payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash payment processing 101 flow is positive, which is the payback year.

If the calculated payback period is less than the desired period, this may be a safer investment. In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs). 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.

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. Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money. 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.