Knowing how to calculate payback period is crucial for companies and investors to determine how long it would take to regain their initial investment. The payback period is an easy financial measurement that assists in calculating how long it would take for an investment to earn enough cash flow to pay its initial price. It is extensively applied in capital budgeting to compare various projects and analyze the investment risk. In this article, we will discuss the definition of the payback period, its calculation techniques, formulas, advantages, and disadvantages.
Payback Period Meaning
The payback period is when an investment produces enough cash flow to pay back its original cost. It is among the most popular financial decision-making tools due to its simplicity and ease of use.
The payback period allows companies to know when it will take to recover an investment. It is similar to the break-even point, but it is measured in years rather than in units. In general, shorter payback periods mean quicker returns and increased attractiveness for the investment.
The payback period allows companies to assess potential investments and associated risks. It is a straightforward and speedy way to compare projects. Businesses also use it to determine the return on investment in new assets or equipment upgrades. (For example, a local business owner might calculate the payback period of installing solar panels to determine whether or not they’re a sound investment.)
How to Calculate Payback Period?
The payback period measures the time an investment requires to pay for itself. It is determined by dividing the total amount invested by money received yearly.
Step 1: Find the Initial Investment
This is the total money spent on the machine, plant, or project. Example: A company invests ₹12,00,000 in a new machine.
Step 2: Find the Annual Cash Inflows
This is the amount of money the project earns every year. Example: The machine generates ₹3,00,000 per year in savings.
Step 3: Apply the Payback Period Formula
Payback Period=Initial Investment/Annual Cash Inflows
Using the example:
Let’s assume the initial investment on a machine is ₹12,00,000, and the annual cash flow is ₹3,00,000
12,00,000/3,00,000=4 years
This means the company will recover its ₹12,00,000 investment in 4 years.
Payback Period with Unequal Cash Flows
Sometimes, a project does not earn the same amount every year. In such cases, we add the yearly earnings until the total investment is recovered.
A company invests ₹10,00,000 in a project with the following cash inflows:
| Year | Cash Earned (₹) | Total Earned So Far (₹) |
| 1 | 3,00,000 | 3,00,000 |
| 2 | 3,50,000 | 6,50,000 |
| 3 | 2,50,000 | 9,00,000 |
| 4 | 2,00,000 | 11,00,000 |
After 3 years, the company has earned ₹9,00,000.
The remaining amount to recover is 10,00,000−9,00,000= 1,00,000. In Year 4th, the company earned ₹2,00,000, more than needed.
To find the fractional year, we divide the remaining amount by Year 4 earnings:
1,00,000/2,00,000=0.50
Now, we add this to 3 years:
3+0.25=3.50 years
So, the investment will be recovered in 3.50 years.
Payback Period Formula
The basic payback period method formula is: Payback Period=Initial Investment/Annual Cash Inflows
But when cash flows are not regular, we utilize a cumulative cash flow method:
- Cumulative Cash Flow Calculation: Sum annual cash flows until the sum reaches or surpasses the initial outlay.
- Fractional Year Adjustment: If the investment is returned between years, use:
Payback Period=Previous Year Of Recovery+Unrecouped Investment/Net Cash Flow in coming Year.
Advantages of Payback Period
The payback period is a simple yet effective tool to analyze investments. Its positive measures are useful for risk assessments, quick decision-making, and short-term projects, and they help businesses determine the time to recover initial outlay costs.
Simple and Easy to Calculate
One of the simplest ways to evaluate an investment is the payback period. It has only two main inputs: the money put in and the net cash inflows yearly. The calculation is straightforward, and once a business knows how quickly it can recover its investment, it can make an informed decision.
Quick Decision-Making
Businesses need ways to help make the best investments in a faster, more efficient environment. The payback period is a quick decision-making tool that shows how long it will take to recoup costs. Because shorter payback periods are more attractive, firms need only to compare options on that basis; no complex financial analysis is necessary to determine which option is optimal.
Useful for Risk Assessment
Investments always have some financial risk, but the payback period alleviates uncertainty. For example, a shorter payback period implies that a business gets its money back quickly, reducing the risk of losses. As a result, it is an excellent tool for providing insight into whether speculative investments should be made or if sufficient resources exist for project completion.
Ideal for Short-Term Projects
A few investments need immediate returns, and the payback period is ideal for assessing these projects. This method is used by businesses that require quick capital recovery to help them decide if an investment is worthwhile. This is particularly beneficial for sectors where technology evolves quickly, and long-term investments run the risk of obsolescence.
Provides a Basic Investment Benchmark
Before investing, many companies compare a series of projects. The payback period is a simple yardstick for determining the most profitable option. Although not all-encompassing of long-term returns, it helps businesses remove investments with lengthy payback periods and filter those with the ability to pay back within shorter periods.
Disadvantages of Payback Period
Although the payback period is easy to use as an investment measurement, it has some deficiencies. It disobeys the time value of money, distant profitability, as well as the economic risks that are involved when making large investments. Knowledge about these limitations can assist companies in selecting better assessment tools for investments.
Ignores Time Value of Money
The payback period also does not consider the time value of money; that is, future cash inflows are treated as having the same worth as today’s money. In fact, due to inflation, cash erodes over time. Due to this, the payback period is not so accurate for long-term financial planning.
Does Not Consider Cash Flows After Payback Period
The payback period disregards any further cash flows after the investment recoups. While this shows how a project can generate high profits after the payback period, it does not factor in those profits. That encourages companies to select projects that offer quick returns rather than those that may deliver greater profitability over the long haul.
Not Suitable for Long-Term Investments
While the payback period is great for short projects, the calculation breaks down for investments that take years to start producing profit. Long-term projects (like road or bridge construction), which might provide lower returns in the short term but significantly higher cumulative profitability over time, are not adequately recognized in the payback method.
Fails to Account for Risk and Inflation
The payback period ignores economic risks, inflation, and interest rates, which affect the real value of returns. A project that appears to be profitable today may be much less valuable strips of economic changes. Subtracting adjusted factors can lead to businesses underestimating financial risks.
How to Calculate Discounted Payback Period?
The discounted payback period adjusts future cash flows by considering the time value of money. It is calculated using the formula:
Steps to Calculate Discounted Payback Period
- Identify Initial Investment.
- Apply Discount Rate (e.g., 10%) to future cash flows.
- Calculate Present Value of Cash Flows using:
- Compute Cumulative Discounted Cash Flow.
- Find the Year in Which Investment is Recovered.
Example of Discounted Payback Period Calculation
A company invests ₹10,00,000 with a 10% discount rate. The cash flows are:
| Year | Cash Flow (₹) | Present Value Factor (10%) | Discounted Cash Flow (₹) | Cumulative DCF (₹) |
| 1 | 2,50,000 | 0.909 | 2,27,250 | 2,27,250 |
| 2 | 3,00,000 | 0.826 | 2,47,800 | 4,75,050 |
| 3 | 3,50,000 | 0.751 | 2,62,850 | 7,37,900 |
| 4 | 4,00,000 | 0.683 | 2,73,200 | 10,11,100 |
Investment is recovered between Year 3 and Year 4. Discounted Payback Period = 3.8 years.
Calculate Payback Period FAQs
How to determine payback period of investment?
Apply the formula: Payback Period=Initial Investment/Annual Cash Inflows
What is the drawback of payback period?
It overlooks the time value of money and long-run profitability.
How to compute discounted payback period?
By discounting future cash flows before adding them up.
What is a good payback period?
A short payback period is desirable, normally less than 5 years.
Is the payback period the optimal investment approach?
No, it must be used in conjunction with NPV and IRR for improved decision-making.
