Payback Period: Definition, Formula & Examples

However, it’s likely he would search out another machine to buy, one with a longer life, or shelf the idea altogether. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Whether you’re new to investing or already have a portfolio started, there are many tools available to help you be successful. One great online investing tool is SoFi Invest® online brokerage platform.

• As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
• By calculating how fast a business can get its money back on a project or investment, it can compare that number to other projects to see which one involves less risk.
• Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.
• This means that it will actually take Jimmy longer than 6 years to get back his original investment.
• You can easily calculate the Payback Period using Formula in the template provided.
• Payback period is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor.

When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods. 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.

Is the Payback Period the Same Thing As the Break-Even Point?

Using the payback period to assess risk is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR). 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. 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.

• 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.
• Let us now calculate the discounted values of the cash inflows of the project.
• The averaging process delivers a precise idea of the payback period when the cash flow is steady.
• Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering.

This is so the money is not tied up for too long and management can reinvest it elsewhere, perhaps in additional equipment that will generate more profit. But what if the machine for Jimmy’s Jackets will no longer be profitable past 3 years? The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow.

Irregular Cash Flow Each Year

•   The payback period is the estimated amount of time it will take to recoup an investment or to break even. As you can see, the first year’s discounted value for 8% is 0.926 that we calculated using the expression above. However, the present value table is normally given in exams and you can use it to derive the discounted values for different discount rates. This method simple payback period also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments. A speedy return may not always be the priority of a business because long-term investments are also rewarded in many ways. Examining the payback period is helpful to identify several investment opportunities that may be available.