The shorter the payback period of a project, the greater the project’s liquidity. It is possible that a project will not fully recover the initial cost in one year but will have more than recovered its initial cost by the following year. In these cases, the payback period will not be an integer but will contain a fraction of a year.
Calculating the Payback Period
Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period. 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.
- Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows.
- Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.
- For example, a firm may decide to invest in an asset with an initial cost of $1 million.
- The answer is found by dividing $200,000 by $100,000, which is two years.
- So if you pay an investor tomorrow, it must include an opportunity cost.
Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to backup withholding definition generate $25 million per year in net cash flows for 7 years. The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow.
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. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.
Projecting a retained earnings equation break-even time in years means little if the after-tax cash flow estimates don’t materialize. Since some business projects don’t last an entire year and others are ongoing, you can supplement this equation for any income period. For example, you could use monthly, semi annual, or even two-year cash inflow periods. The cash inflows should be consistent with the length of the 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).
Understanding the Payback Period
So if you pay an investor tomorrow, it must include an opportunity cost. The principal advantage of the payback period method is its simplicity. It is easy for managers who have little finance training to understand. The payback measure provides information about how long funds will be tied up in a project.
Understanding the Payback Period and How to Calculate It
The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money.
A third drawback of this method is that cash flows after the payback period are ignored. However, Projects B and C end after year 5, while Project D has a large cash flow that occurs in year 6, which is excluded from the analysis. The payback period method provides a simple calculation that the managers at Sam’s Sporting Goods can use to evaluate whether to invest in the embroidery machine. The payback period calculation focuses on how long it will take for a company to make enough free cash flow from the investment to recover the initial cost of the investment. The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments.
Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. Sam’s Sporting Goods is expecting its cash inflow to increase by $16,000 over the first four years of using the embroidery machine. In other words, it takes four years to accumulate $16,000 in cash inflow from the embroidery machine and recover the cost of the machine.
One way corporate financial analysts do this is with the payback period. The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven. 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. That’s what the payback period calculation shows, adding up your yearly savings until the $400,000 investment has been recouped. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project.
The discounted payback period determines the payback period using the time value of money. This means the amount of time it would take to recoup your initial investment would be more than six years. According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. The Payback Period shows how long it takes for a business to recoup an investment. This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them.
How to Calculate Payback Period
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. It’s important to note that not all investments will create the same amount of increased cash flow each year.
Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). Under payback method, an investment project is accepted or rejected on the basis of payback period.
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. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter the payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows.
The main reason for this is it doesn’t take into consideration the time value of money. Theoretically, longer cash sits in the investment, the less it is worth. In order to account for the time value of money, the discounted payback period must be used to discount the cash inflows of the project at the proper interest rate. A second disadvantage of using the payback period method is that there is not a clearly defined acceptance or rejection criterion. When the payback period method is used, a company will set a length of time in which a project must recover the initial investment for the project to be accepted.