According to payback method, the project that promises a quick recovery of initial investment is considered desirable. 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.
What is the Payback Period?
In its simplest form, the payback period is calculated by dividing the initial investment by the annual cash inflow. 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. 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 discounted payback period, on the other hand, incorporates the time value of money by discounting future cash flows to their present value. The discount rate, often aligned with the company’s weighted average cost of capital (WACC), is essential in this calculation.
- For instance, if a company’s WACC is 8%, future cash inflows are discounted at this rate, typically extending the payback period compared to the non-discounted method.
- Similarly, manufacturing firms may experience fluctuations due to supply chain disruptions or changing raw material costs, which are crucial to accurate financial planning.
- Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment.
- This formula assumes consistent cash inflows, which is common in stable environments.
- It is considered to be more economically efficient and its sustainability is considered to be more.
- The payback period is the amount of time it takes to recover the cost of an investment.
Non-Discounted vs. Discounted Calculation
This can result in investors overlooking the long-term benefits of the investment since they’re too focused on short-term ROI. • Downsides of using the payback period include that it does take into account the time value of money or other ways an investment might bring value. Others like to use it as an additional point of reference in a capital budgeting decision framework. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested.
Example 1: Even Cash Flows
- Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment.
- If you have any questions or need help getting started, SoFi has a team of professional financial advisors available to help you reach your personal financial goals.
- Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments.
- 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).
- The discounted payback period formula adjusts future cash flows to reflect their present value.
The payback method should not be used as the bookkeeping and payroll services sole criterion for approval of a capital investment. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. Using the subtraction method, subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved. This approach works best when cash flows are expected to vary in subsequent years.
The Value Engineering Process: Steps to Improve Financial Efficiency
Companies use this to know when they will break even on their investment. The payback period is the expected number of years it will take for a company to recoup the cash it invested in a project. Every investor, be it individual or corporate will want to assess how long it will take for them to get back the initial capital. This is because it is always worthwhile to invest in an opportunity in which there is enough net revenue to cover the initial cost. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. The payback period doesn’t take into consideration other ways an investment might bring value, such as partnerships or brand cash flow awareness.
Payback method with uneven cash flow:
When cash flows vary, a cumulative approach is necessary, subtracting each year’s inflow from the initial investment until it is fully recovered. The payback period is a metric in the field of finance that helps in assessing the time requirement for recovering the initial investment made in a project. It has a wide usage in the investment field to evaluate the viability of putting money in an opportunity after assessing the payback time horizon.
This also shows regressive returns and resource misuse, leading to lower profitability over a prolonged period. The payback period tells how long it takes for an investment to recover its cost. It is calculated by dividing the total investment by the money earned each year.
Simply put, it is the length of time an investment reaches a breakeven point. The firm breaks even in approximately 4 years and 3 months, including the time value of money. This method gives a better estimate of time to break even and is applicable for assessing long-term investments. Note that in both cases, the calculation is based on cash flows, not accounting net income (which is subject to non-cash adjustments). Discover how to calculate payback, understand its variables, and explore its role in assessing liquidity and cash flow variations. This 20% represents the rate of return the project or investment gives every year.
