INVESTMENT PAYBACK PERIOD: CALCULATION AND EXAMPLES - DUDAS - 2025

The period of return on investment or payback is the amount of time it takes a company to recover the cost of your original investment in a project, when net cash flow is zero.

It is an important determinant of whether the project is undertaken, as longer payback periods are generally not desirable for investment positions.

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The payback period ignores the time value of money, unlike other capital budgeting methods, such as net present value, internal rate of return, and discounted cash flow.

This concept does not consider the presence of an additional cash flow that may arise from an investment in the periods after obtaining the full repayment.

As an analysis tool, the payback period is frequently used because it is easy to apply and understand for most people, regardless of academic or job field training.

What does it consist of?

Much of corporate finance is about capital budgets. One of the most important concepts that every corporate financial analyst must learn is how to value different investments or operational projects.

The analyst must find a reliable way to determine the most profitable project or investment to undertake. One way that corporate financial analysts do this is with the payback period.

Capital budget and payback period

Most capital budgeting formulas take into account the time value of money. The time value of money is the idea that money today is worth more than the same amount in the future, due to the current earning potential of money.

Therefore, if you pay an investor tomorrow, you must include an opportunity cost. The time value of money is a concept that assigns a value to this opportunity cost.

The payback period does not take into account the time value of money. It is simply determined by counting the number of years it takes to recover the invested funds.

For example, if it takes five years to recoup the investment cost, the payback period for the investment is five years.

Some analysts favor the payback method for its simplicity. Others like to use it as an additional reference point in a capital budgeting decision framework.

How is it calculated?

The formula for calculating the payback period depends on whether the cash flows per project period are uniform or uneven.

If they are the same, the formula to calculate the payback period is as follows:

Investment payback period = Initial investment / Cash flow per period.

When the cash flows are unequal, the accumulated cash flows for each period must be estimated. Then the following formula should be used to calculate the payback period:

Investment payback period = Total payback time + (Unrecovered payback of investment at the beginning of the year / cash flow in the following year).

The shorter the payback period for a project, the more attractive the project will be to management. In addition, management generally sets a maximum payback period that a potential project must meet.

Project to accept

When two projects are compared, the project to be accepted is the one that meets the maximum payback period and has the shortest payback period.

It is a very simple calculation, which does not take into account the time value of money. However, it is a good indicator to measure the risks of a project.

The decision rules for the payback periods are as follows: If the payback period is less than the maximum allowed, the project is accepted. If the payback period is longer than the maximum allowed, the project is rejected.

Keep in mind that the investment payback period calculation uses cash flows, not net income. Also, the payback calculation does not address the total profitability of a project.

Rather, the payback simply calculates how quickly a business will recoup its investment in cash.

Examples

Company A case

Suppose Company A invests $ 1 million in a project that is expected to save company $ 250,000 each year.

The payback period for this investment is 4 years, which is found by dividing $ 1 million by $ 250,000.

Let's consider another project that costs $ 200,000, and has no associated cash savings, but will see the company increase its revenue by $ 100,000 each year for the next 20 years ($ 2 million).

Clearly, the second project can make the company double the money, but how long will it take to recoup the investment? The answer is found by dividing $ 200,000 by $ 100,000, which is 2 years.

The second project will take less time to pay off and the company's profit potential is higher.

Based solely on the payback period method, the second project is a better investment.

Newco case

Suppose the Newco company is deciding between two machines (Machine A and Machine B) to add production capacity to its existing plant. The company estimates that the cash flows for each machine are as follows:

You want to calculate the payback period for the two machines, using the previous cash flows and decide which new machine Newco should accept.

Let's say the maximum payback period that the company sets is five years.

First, it would be helpful to determine the cumulative cash flow for the project for each machine. This is done in the following table:

Payback period for Machine A = 4 + 1,000 / 2,500 = 4.4 years.

Payback period for Machine B = 2 + 0 / 1,500 = 2.0 years.

Both machines meet the maximum period allowed by the company of five years to recover the investment.

However, Machine B has the shortest payback period and is the project that Newco should accept.

References

1. Investopedia (2018). Payback Period. Taken from: investopedia.com.
2. Steven Bragg (2017). Accounting Tools. Payback method - Payback period formula. Taken from: accountingtools.com.
3. Accounting Explained (2018). Payback Period. Taken from: accountingexplained.com.
4. CFI (2018). Payback Period. Taken from: corporatefinanceinstitute.com.
5. Harold Averkamp (2018). How do you calculate the payback period? Accounting Coach. Taken from: accountingcoach.com.