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payback period formula

The point after breaking even is when the total of discounted cash inflows will exceed the initial cost. It measures the time it takes to regain the invested capital and reach the break-even point. If a venture has a 10-year period of payback, the measure does not consider the cash flows after the 10-year time frame.

Alternatives to the payback period calculation

The term payback period refers to 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. Calculating the payback period is straightforward since you only need to divide the annual inflow (cash flow) by the initial outflow (investment). Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years.

Example of Calculating the Payback Period

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach. The sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

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In the arsenal of corporate finance tools for capital budgeting, it’s worth seeing how it compares to other capital budgeting methods such as NPV, IRR, modified IRR, and profitability index. The rate of return can be positive or negative, thus, resulting in a gain or a loss for a specific investment. Ultimately, the aim of project investment is to achieve profitability beyond that in which it turns breakeven. It provides a straightforward and easy way for calculating even and uneven cash flows. The simplest way to differentiate between even and uneven cash flows is by evoking the concept of an annuity.

payback period formula

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. The best option would depend on your other available options and the rate of return available for reinvesting your initial investment. Once the payback period has been completed, the business will enter the profitability period, ceteris paribus, which means that “other things being equal or held constant”.

  • Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.
  • For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
  • Take an example where a project requires an initial investment of $150,000.
  • The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments.

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Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. Alternative measures of “return” preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment. This still has the limitation of not considering cash flows after the discounted payback period.

Pros of payback period analysis

Understanding the nuances, advantages, and limitations of each metric is essential to make informed capital budgeting decisions. With this in mind, it becomes clear that the tool is insufficient for estimating the value of an investment and its returns. Conversely, if proceeds after the period have a dramatic uptick and move into the green, then the investment is a wise decision. A good place to start getting to grips with them is our Accounting Foundations Course and the Excel Modeling Course. Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets.