From the finished output of the first example, we can see the answer comes out to 2.5 years (i.e., 2 years and 6 months). We’ll now move to a modeling exercise, which you can access by filling out the form below. As you can see in the example below, a DCF model is used to graph the payback period (middle graph below).

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. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Also, the payback period does not assess the riskiness of the project.

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. No such adjustment for this is made in the payback period calculation, instead it assumes this is a one-time cost. By calculating how fast a business can get its money back on a project or investment, it can compare that number to other projects to see which one involves less risk.

What Are the Criticisms of the Payback Period?

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. The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. 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 is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor.

Payback Period Calculation Example

Are you still undecided about investing in new machinery for your manufacturing business? Perhaps you’re torn between two investments and want to know which one can be recouped faster? 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. Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business.

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The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. The payback period refers to how long it takes to reach that breakeven. The answer is found by dividing $200,000 by $100,000, which is two years.

Discounted Payback Period Calculation Analysis

1. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
2. For example, if it takes five years to recover the cost of an investment, the payback period is five years.
3. Input the known values (year, cash flows, and discount rate) in their respective cells.
4. Use Excel’s present value formula to calculate the present value of cash flows.
5. Jim estimates that the new buffing wheel will save 10 labor hours a week.

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. For example, if it takes five years to recover the cost of an investment, the payback period is five years. Payback period doesn’t take into consideration the time value of money and therefore may not present the true picture when it comes to evaluating cash flows of a project.

Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. 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. Management uses the cash payback period equation to see how quickly they will get the company’s money back from an investment—the quicker the better.

What Is an Acceptable 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 completed contract method meaning examples explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.

If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. Let’s say the net cash flow amount is expected to be higher, say $240,000 annually. 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.

It’s important to note that not all investments will create the same amount of increased cash flow each year. For instance, if an asset is purchased mid-year, during the first year, your cash flow would be half of what it would be in subsequent years. When that’s the case, each year would need to be considered separately. The table is structured the same as the previous example, however, the cash flows are bookkeeping and accounting services in colorado discounted to account for the time value of money.

Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less.

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. As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. Let’s say Jimmy does buy the machine for $720,000 with net cash flow expected at $120,000 per year.