The payback period can help investors decide between different investments that may have a lot of similarities, as they’ll often want to choose the one that will pay back in the shortest amount of time. 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. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000.

A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. 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). 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.

## Payback Period Calculation Example

In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. 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. 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.

- The discounted payback period is the number of years it takes to pay back the initial investment after discounting cash flows.
- Simply put, it is the length of time an investment reaches a breakeven point.
- As such, it should not be used alone as an investment appraisal technique – other methods should be used such as ROI, NPV or IRR.
- Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months).
- The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
- For instance, new equipment might require a significant amount of expensive power, or might not be able to run as often as it would need to in order to reach the payback goal.

Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. Longer payback periods are not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a simple payback period formula profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future. For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs. That’s why a shorter payback period is always preferred over a longer one.

## What is the Payback Method?

WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted. For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments. WACC can be used in place of discount rate for either of the calculations. The payback method should not be used as the sole criterion for approval of a capital investment.

- If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment.
- Here, future cash inflows are discounted using a particular rate, reflecting their present value.
- The discounted payback period is commonly utilized in capital budgeting procedures to assess the profitability of a project.
- 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.
- Knowing the payback period is helpful if there’s a risk of a project ending in the future.
- Our GST Software helps CAs, tax experts & business to manage returns & invoices in an easy manner.
- However, one limitation of the payback period is its disregard for the time value of money, which refers to the declining worth of money over time.

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. 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. As you can see, using https://www.bookstime.com/ 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. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment.

## Uses of Payback Period in Corporate Finance

The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000. For the most thorough, balanced look into a project’s risk vs. reward, investors should combine a variety of these models. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year.

## Leave a Reply