Cash outflows include any fees or charges that are subtracted from the balance. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. On the other hand, payback period calculations can be so quick and easy that they’re overly simplistic.

Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. In this case, the payback period would be 4 years because 200,0000 divided by 50,000 is 4. You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one.

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5.

For example, if it takes five years to recover the cost of an investment, the payback period is five years. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.

- In fact, it would be preferable to calculate the IRR to compare these two investments.
- For example, three projects can have the same payback period; however, they could have varying flows of cash.
- The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash.
- More specifically, it’s the length of time it takes a project to reach a break-even point.

Sam’s Sporting Goods is expecting its cash inflow to increase by $16,000 over the first four years of using the embroidery machine. In other words, it takes four years to accumulate $16,000 in cash inflow from the embroidery machine and recover the cost of the machine. The decision rule using the payback period is to minimize the time taken for the return on investment. 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. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years).

## Discounted Payback Period Calculation Analysis

For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows.

## Discounted Payback

In order to purchase the embroidery machine, Sam’s Sporting Goods must spend $16,000. During the first year, Sam’s expects to see a $2,000 benefit from purchasing the machine, but this means that after one year, the company will have spent $14,000 more than it has made from the project. During the second year that it uses the machine, Sam’s expects that its cash inflow will be $4,000 greater than it would have been if it had not had the machine. Thus, after two years, the company will have spent $10,000 more than it has benefited from the machine. This process is continued year after year until the accumulated increase in cash flow is $16,000, or equal to the original investment. The payback period with the shortest payback time is generally regarded as the best one.

The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. 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. Figure 8.6 repeats the nonprofit fundraising, part 2 cash flow estimates for Julie Jackson’s planned purchase of a copy machine for Jackson’s Quality Copies, the example presented at the beginning of the chapter. Payback period doesn’t take into consideration the time value of money and therefore may not present the true picture when it comes to evaluating cash flows of a project.

Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost. One way corporate financial analysts do this is with the payback period. As mentioned above, Payback Period Method neither takes time value of money nor cash flows beyond the payback period into consideration. This means that the terminal or the salvage value would not be considered.

## Defining the Payback Method

A payback period, on the other hand, is the time it takes to recover the cost of an investment. 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. Whereas the payback period refers to https://simple-accounting.org/ the time it takes to reach the breakeven point. Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

## Evaluation of the Payback Method

The IRR for the first investment is 4 percent, and the IRR for the second investment is 18 percent. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. A third drawback of this method is that cash flows after the payback period are ignored. However, Projects B and C end after year 5, while Project D has a large cash flow that occurs in year 6, which is excluded from the analysis. A second disadvantage of using the payback period method is that there is not a clearly defined acceptance or rejection criterion.

No matter how careful the planning and analysis, a business is seldom sure what future cash flows will be. Some projects are riskier than others, with less certain cash flows, but the payback period method treats high-risk cash flows the same way as low-risk cash flows. Second, it only considers the cash inflows until the investment cash outflows are recovered; cash inflows after the payback period are not part of the analysis. Both of these weaknesses require that managers use care when applying the payback method. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project.

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. Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money.