Payback Period: Definition, Formula & Examples

If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Management then looks at a variety of metrics in order to obtain complete information. Comparing various profitability metrics for all projects is important when making a well-informed decision. The formula for the simple payback period and discounted variation are virtually identical.

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. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis.

What Are Some of the Downsides of Using 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. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment. One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year.

Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. 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.

• Over the next five years, the firm receives positive cash flows that diminish over time.
• Investments with higher cash flows toward the end of their lives will have greater discounting.
• Initially the project involves a cash outflow, arising from the original investment of £500,000 and some project losses in Year 1 of £50,000.
• Company C is planning to undertake a project requiring initial investment of $105 million.
• The second project will take less time to pay back, and the company’s earnings potential is greater.

On the other hand, payback period calculations can be so quick and easy that they’re overly simplistic. The payback period is the amount of time it would take for an investor to recover a tax deductible expenses for photographers project’s initial cost. The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in.

Using the Payback Method

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. The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. 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. 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.

Payback Period vs. Discounted Payback Period

In this case, the payback period would be 4 years because 200,0000 divided by 50,000 is 4. You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one. Generally, a long payback period is determined by your own comfort level – as long as you are paying off one investment, you’ll be less able to invest in newer, promising opportunities. 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 endeavor.

Cons of payback period analysis

The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.

Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects. For lower return projects, management will only accept the project if the risk is low which means payback period must be short. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods.

Payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. 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. 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. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake.

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.