When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment. The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.

- Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost.
- J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor.
- Since some business projects don’t last an entire year and others are ongoing, you can supplement this equation for any income period.
- In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows.
- The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows.

A modified variant of this method is the discounted payback method which considers the time value of money. The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. 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.

## Payback method

Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator. The study of cash flow provides a general indication of solvency; generally, having adequate cash reserves is a positive sign of financial health for an individual or organization. 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. In this case, the payback method does not provide a strong indication as to which project to choose.

Cumulative net cash flow is the sum of inflows to date, minus the initial outflow. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. This method also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments. In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered.

## Evaluation of the Payback Method

The first is that it fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day’s earning potential. The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost. The breakeven point is a specific price or value that an investment or project must reach so that the initial cost of that investment or project is completely returned.

## What Is the Payback Period?

Every year, your money will depreciate by a certain percentage, called the discount rate. Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. 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.

When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to “doing nothing,” payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). As a https://simple-accounting.org/ general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive.

There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period. A payback period refers to the time it takes to earn back the cost of an investment. More specifically, it’s the length of time it takes a project to reach a break-even point.

The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. On the other hand, Jim could purchase the sand blaster company capability statement example for job application and save $100 a week from without having to outsource his sand blasting. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

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.

As the equation above shows, the payback period calculation is a simple one. 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. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. The answer is found by dividing $200,000 by $100,000, which is two years.

This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time. Despite its appeal, the payback period analysis method has some significant drawbacks.

The breakeven point is the level at which the costs of production equal the revenue for a product or service. Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period. Since the payback period focuses on short term profitability, a valuable project may be overlooked if the payback period is the only consideration.

Since many capital investments provide investment returns over a period of many years, this can be an important consideration. 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. 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. Payback period is a financial or capital budgeting method that calculates the number of days required for an investment to produce cash flows equal to the original investment cost. In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven.