The payback period is a simple measure of how long it takes for a company to recover its initial investment in a project from the project’s expected future cash inflows. As such, it should not be used alone as an investment appraisal technique – other methods should be used such as ROI, NPV or IRR. In its simplest form, the payback period is calculated by dividing the initial investment by the annual cash inflow. The payback period is the amount of time needed to recover the initial outlay for an investment.
Advantages and Disadvantages of the Payback Period
- In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks.
- By following these simple steps, you can easily calculate the payback period in Excel.
- The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money.
- Are you looking to calculate the payback period for an investment project using Microsoft Excel?
- Without considering the time value of money, it is difficult or impossible to determine which project is worth considering.
For example, you could use monthly, semi annual, or even two-year cash inflow periods. 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. 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. Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes.
- The payback period is the amount of time it would take for an investor to recover a project’s initial cost.
- This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential.
- 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.
- The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years.
How to calculate the payback period
If one has a longer payback period than the other, it might not be the better option. Payback period is a fundamental investment appraisal technique in corporate financial management. It is a measure of how long it takes for a company to recover its initial investment in a project. It is one of the simplest capital budgeting techniques and, for this reason, is commonly used to evaluate and compare capital projects. For example, a project cost is $ 20,000, and annual cash flows are uniform at $4,000 per annum, and the life of the asset acquire is 5 years, then the payback period reciprocal will be as follows. It’s important to consider other financial metrics in conjunction with payback period to get a clear picture of an investment’s profitability and risk.
How to Calculate the Payback Period With Excel
Whether you’re new to investing or already have a portfolio started, there are many tools available to help you be successful. The investing platform lets you research and track your Accounting For Architects favorite stocks and ETFs. You can easily buy and sell with just a few clicks on your phone, and view your portfolio on one simple dashboard. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months).
Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. 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).
Company
Input the known values (year, cash flows, and discount rate) in their respective cells. Use Excel’s present value formula to calculate the present value of cash flows. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. The payback method should not be used as the sole criterion for approval of a capital investment.
This is a valuable metric for fund managers and analysts who use it to determine the feasibility of an investment. However, it is to be noted that the method does not take into account time value of money. Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account. The time value of money is the idea that cash will be worth more in the future than it is worth today, due to the amount of interest that it can generate. Not only does this apply to the initial capital put into an investment, but it’s also important because as an investment generates returns, that cash can then be reinvested into something else that earns interest or income.
Payback Period Example
- Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost.
- In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow.
- It also doesn’t consider cash inflows beyond the payback period, which are still relevant for overall profitability.
- A projected break-even time in years is not relevant if the after-tax cash flow estimates don’t materialize.
- For example, imagine a company invests $200,000 in new manufacturing equipment which results in a positive cash flow of $50,000 per year.
- However, there’s a limit to the amount of capital and money available for companies to invest in new projects.
The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes. The payback period calculation doesn’t account for the time value of money or consider cash inflows beyond the payback period, which are still relevant for overall profitability. Therefore, businesses need to use other financial metrics in conjunction with payback period to make informed investment decisions.
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For example, three projects can have the same payback period with varying break-even points because of the varying flows of cash each project generates. Now it’s time to enter the data you have gathered into the Excel spreadsheet. This sum tells you how much cash you’ve generated up until that point in time. To determine how to calculate payback period in practice, you simply divide the initial cash outlay of a project by the amount of net cash inflow that the project generates each year. For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year. It’s important to note that while payback period is an essential metric, it’s not a comprehensive measure of investment profitability.