What Is A Payback Period? How Time Affects Investment Decisions

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 is the discount rate used to compute the present value of future cash flows. WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted. For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments.

The exceptional cases can pay back their acquisition costs within 6 months. For B2B businesses selling to SMBs, less than 6 months is GREAT, 12 months is GOOD, and 18 months is OK. And similarly, the exceptional cases get their customers to prepay their contract and recoup all acquisition costs up-front.

Payback Period Example

So let’s work on this example and see how we can calculate the payback period for a cash flow. It does not take into account, the cash flows that occur after the payback period. This means that a project having very good cash inflows but beyond its payback period may be ignored. The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven. The payback method simply projects incoming cash flows from a given project and identifies the break even point between profit and paying back invested money for a given process. 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.

The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflow for the investment. They discount the cash inflows of the project by the cost of capital, and then follow usual steps of calculating the payback period. Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0 years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. The payback period for this capital investment is 3.0 years.

Payback Method

Depending on the calculated payback period of a project, management can decide to either accept or reject the project. An investment project will be accepted if the payback period is less than or equal to the management’s maximum desired payback period. So, shorter payback periods are always preferred because if the firm can regain its initial price in cash, the investment automatically becomes more preferred and acceptable. An investment project with a short payback period promises the quick inflow of cash. It is therefore, a useful capital budgeting method for cash poor firms.

• Please note that if the discount rate increases, the distortion between the simple rate of return and discounted payback period increases.
• Any investments with longer payback periods are generally not as enticing.
• The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes.
• On the other hand, payback period calculations can be so quick and easy that they’re overly simplistic.
• For example, cash investments may be required at several stages, such as cash outlays for periodic upgrades.

Also, the payback calculation does not address a project’s total profitability over its entire life, nor are the cash flows discounted for the time value of money. The yearly cash flow from an investment or project is the capital that the investment generates. While the cash flow may fluctuate sometimes, you can use one number to represent the average yearly cash flow.

3 2 Payback Period

A short payback period reduces the risk of loss caused by changing economic conditions and other unavoidable reasons. Free AccessFinancial Modeling ProUse the financial model to help everyone understand exactly where your cost and benefit figures come from. The model lets you answer “What If?” questions, easily and it is indispensable for professional risk analysis.

“Payback tells you when you will get your initial investment back, but it doesn’t take into account the fact that you don’t have your money for all that time,” he says. For that reason, net present value is often the preferred method. Payback is perhaps the simplest method of investment appraisal. For example, imagine a company invests $200,000 in new manufacturing equipment which results in a positive cash flow of $50,000 per year. Calculate the payback period for an investment with following cash flow. This survey also shows that companies with capital budgets exceeding $500,000,000 are more likely to use these methods than are companies with smaller capital budgets. The time value of money is an important consideration for a business.

Defining The Payback Method

In order to account for the time value of money, the discounted payback period must be used to discount the cash inflows of the project at the proper interest rate. The payback method evaluates how long it will take to “pay back” or recover the initial investment.

An implicit assumption in the use of the payback method is that returns to the investment continue after the payback period. The payback method does not specify any required comparison to other investments or even to not making an investment. Longerpayback periodsare not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future.

What Are Some Disadvantages To Using The Payback Period Formula?

If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less. So again, as you can see here, the cumulative discounted cash flow– the sign of cumulative discounted cash flow changes from negative to positive between year 4 and 5. So the payback period for the discounted cash flow– discounted payback period– is 4 plus a fraction. The fraction equals the cumulative cash flow at year 4, cumulative discounted cash flow, at year 4 divided by this difference. Divided by the difference between cumulative cash flow– cumulative discounted cash flow– of year 5 and year 4, which equals the cash flow at year 5.

Previously we mentioned that companies look for the shortest https://www.bookstime.com/s. 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? Payback also ignores the cash flows beyond the payback period, thereby ignoring the profitability of the project.

Disadvantages Of The Payback Method

No such discount is allocated for in the payback period calculation. This means that it will actually take Jimmy longer than 6 years to get back his original investment. Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets.

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So the payback period for this investment is going to be 3 plus 120 divided by 220, which is going to be 3.55 years. And we can also calculate the payback period from the beginning of the production, as you can see here. Cumulative cash flow at year 2 is the summation of cash flow at year 2 and the cumulative cash flow at year 1, and so on. So as we can see here, the sign of cumulative cash flow changes between year 3 and year 4. So the payback period is going to be 3 plus something– some fraction. The longer the payback period of a project, the higher the risk. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.

A shorter period means they can get their cash back sooner and invest it into something else. Thus, maximizing the number of investments using the same amount of cash. A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. The best payback period is typically the shortest one since companies often aim to recover the initial cost of an investment as quickly as possible. Every investment may have a different time span, so a company should consider the context when determining the shortest possible payback period. For example, the payback period on a commercial real estate improvement project might take decades, while the payback period on a construction project may only take a few years. Investment B costs $75,000, with a return of $15,000 per year.

How Do You Calculate It?

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. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV. Unlike other methods of capital budgeting, the payback period ignores the time value of money .

What Is A Capital Project?

Therefore, the payback period for Investment B would take five years. By comparing these results, the firm determines that Investment A is better because it has a shorter payback period. Businesses need to make investments to grow — that’s a given. But how do you know which investments are likely to be worthwhile? There are a variety of ways to calculate a return on investment —net present value, internal rate of return, breakeven— but the simplest is payback period. So as you can see here, the sign of the cumulative cash flow changes from negative to positive between year 3 to year 4.