A payback period refers to the time it takes to earn back the cost of an investment. More specifically, it’s the length of time it takes a project to reach a break-even point. The breakeven point is the level at which the costs of production equal the revenue for a product or service. 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.
How to Calculate Payback Period in Excel – for non-regular cash flow returns
Here’s a hypothetical example to show how the payback period works. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Others like to use it as an additional point of reference in a capital budgeting decision framework. Cash flow is critical for day-to-day operations and long-term stability. Good cash flow management supports both operational needs and strategic initiatives.
Payback Period (Payback Method)
This 20% represents the rate of return the project or investment gives every year. A project costs $2Mn and yields a profit of $30,000 after depreciation of 10% (straight line) but before tax of 30%. By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform. 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.
Advantages and disadvantages of payback method:
One of the biggest advantages of the payback period method is its simplicity. The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time.
- NPV measures the difference between the present value of cash inflows and the present value of cash outflows over a project’s lifetime.
- The individual considers their retirement goals and time horizon, deciding how much to invest regularly and which funds or assets to allocate within the retirement account to achieve growth over time.
- A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period.
- WACC can be used in place of discount rate for either of the calculations.
- It has a wide usage in the investment field to evaluate the viability of putting money in an opportunity after assessing the payback time horizon.
Payback Period Vs Return On Investment(ROI)
The sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). Investing in real estate involves purchasing physical properties (residential, commercial, or industrial) or investing through Real Estate Investment Trusts (REITs). 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.
Discounted payback period formula
But aside from a strategy, there are other scenarios you can leverage. We explain its formula, how to calculate, example, advantages, disadvantages & differences with ROI. The above article notes that Tesla’s Powerwall is not economically viable for most people. As per the assumptions best fixed asset management software in 2021 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. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching.
As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. 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. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
In this case, the payback method does not provide a strong indication as to which project to choose. 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. Payback period is a fundamental investment appraisal technique in corporate financial management.
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.