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. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. The term payback period refers to the amount of time it takes to recover the cost of an investment.

- While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.
- 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.
- Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade.
- Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money.

If the result returns a positive number over the time period, then the investment is worth pursuing. However, it adds a layer of complexity to the basic model by introducing the total sum of all cash outflows and recording all positive cash inflows. The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.

Multiple internal rates of return occur when dealing with non-normal cash flows, also called unconventional or irregular cash flows. Just like the basic payback period, its modified counterpart calculates the time required to retrieve the invested funds. 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 in capital budgeting refers to the period of time

required for the returnon an investment to “repay” the sum of the

original investment.

## Payback Period Calculator – Excel Template

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. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. 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. A higher payback period means it will take longer for a company to cover its initial investment.

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.

Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost. A payback period, on the other hand, is the time it takes to recover the cost of an investment. Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project’s process. For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years.

Payback period intuitively measures how long something takes to “pay for itself.” All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below. This is calculated by dividing the initial investment by its annual return, as shown in the formula below.

## How do you calculate 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. Let’s assume that a company invests cash of $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is expected to be 4 years ($400,000 divided by $100,000 per year). The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.

## Using the Payback Method

It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. 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. The present value of the discounted future cash flows is compared to the initial capital outlay.

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Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. This formula can managing contacts in xero only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can’t be applied.

This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment. Another option is to use the discounted payback period formula instead, which adds time value of money into the equation. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.

In this article, we will explain the difference between the regular payback period and the discounted payback period. You will also learn the payback period formula and analyze a step-by-step example of calculations. The decision rule using the payback period is to minimize the time taken for the return on investment. The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. Inflows are any items that go into the investment, such as deposits, dividends, or earnings.

We’ll now move to a modeling exercise, which you can access by filling out the form below. Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is met. But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

For instance, a $2,000 investment at the start of the first year that returns $1,500 after the first year and $500 at the end of the second year has a two-year payback period. As a rule of thumb, the shorter the payback period, the better for an investment. Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows.