Discounted Payback Period: What It Is, and How To Calculate It

By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000.

The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow. 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. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets.

How to calculate the payback period

The second project will take less time to pay back, and the company’s earnings potential is greater. 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. 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. 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.

This calculation is useful for risk reduction analysis, since a project that generates a quick return is less risky than one that generates the same return over a longer period of time. There are two ways to calculate the payback equation payback period, which are described below. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.

Payback method

For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month. 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. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.

• According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.
• Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.
• The purchase of machine would be desirable if it promises a payback period of 5 years or less.
• 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.
• The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows.

The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years.

Calculating Payback Using the Averaging Method

In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months). First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.

• There are some clear advantages and disadvantages of payback period calculations.
• The payback period also facilitates side-by-side analysis of two competing projects.
• If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment.
• 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.
• Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business.
• As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached. The discounted payback period determines the payback period using the time value of money. Management uses the cash payback period equation to see how quickly they will get the company’s money back from an investment—the quicker the better. In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks.

Payback Period (Payback Method)

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. For example, a large increase in cash flows several years in the future could result in an inaccurate payback period if using the averaging method. It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. Longer payback periods are not only more risky than shorter ones, they are also more uncertain.

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. 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.