This is how we can calculate payback period using a simple formula and a spreadsheet. In the next section, we will discuss why payback period is important for financial modeling and decision making. This formula uses the interpolation method to calculate the payback period. It adds 3 to the ratio of the unrecovered cost at the start of year 4 (B1) to the cash inflow during year 4 (C4).

The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a how to solve for payback period potential investment or project. 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 it’s laid out for the project. A short payback period may be more attractive than a longer-term investment that has a higher NPV if short-term cash flows are a concern. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as possible. Not all projects and investments have the same time horizon, however, so the shortest possible payback period should be nested within the larger context of that time horizon. Microsoft Excel offers a wide range of tools and functions that make financial calculations easier and more accurate.

Comparison of two or more alternatives – choosing from several alternative projects:

The installation cost will be $5,000, and your savings will be $100 each month. The payback period indicates that it would therefore take you 4.2 years to break even. These were some of the many advantages that are pivotal to the popularization of this method among businesses all around the globe. However, even the Moon has its blemishes and there is no such thing as an only positive method. Every method carries its weaknesses, in its assumptions, procedures, or the key aspects of the subject under study that it drives past.

How to Ungroup Worksheets in Excel

• A short payback period may be more attractive than a longer-term investment that has a higher NPV if short-term cash flows are a concern.
• If you understand the time value of money, you will know that the opportunity cost of having a longer payback period puts OfficePlus at a disadvantage.
• Your payback period calculates the time it takes for an investment to generate enough cash flow to recover its initial cost.
• It is essential for capital formation to gallop upwards and prompt a transformation of the business in the long term, increasing profit margins or total revenue in the short term.

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 is the length of time it will take to break even on an investment. The appropriate timeframe will vary depending on the type of project or investment and the expectations of those undertaking it. Let’s say you’re contemplating installing solar panels on your home.

Payback Period Vs Return On Investment(ROI)

• Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project.
• A modified variant of this method is the discounted payback method which considers the time value of money.
• Every method carries its weaknesses, in its assumptions, procedures, or the key aspects of the subject under study that it drives past.
• Often used by marketers in conjunction with customer acquisition cost (CAC), a short payback period suggests profitable growth.
• In this case, the payback period shall be the corresponding period when cumulative cash flows are equal to the initial cash outlay.

Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money. 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.

What are the advantages and disadvantages of each method?

Typically, this metric is expressed in years or months depending on your risk tolerance and the size of the cash investment. In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples. Let us understand the concept of how to calculate payback period with the help of some suitable examples. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered. Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater. 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).

How do you calculate the payback period?

In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. 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. The simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment for this reason.

The discounted version of this method is extremely useful for real-world investment returns and loan return calculations. They work in entirely different ways as their formulas are as different as can be possible. However, the projects undertaken require long gestation periods wherein returns to investment is nil. Under these circumstances, businesses need to know the details of returns and net profitability before initiating a project. After all the foundational work is cleared, we’ll dive into the concept of the payback period method and its variations, shortly followed by the major advantages and disadvantages of the method.

Limitations of the Payback Period Calculation

Financial models are utilized in this case, or the payback period method as both are reliable tools for project appraisal. Persons involved in finance, especially corporate finance possess a forte in finance and have studied it in dozens of books for years to become professionals at their craft. So, they find little trouble in understanding the value of the payback period and the suitable conditions for its use. Your Payback Period (PBP) is the length of time it takes to recover the cost of an investment. For ease of auditing, financial modeling best practices suggests calculations that are transparent.

How Will I Use This in Real Life?

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period.

This might seem like a long time, but it’s a pretty good payback period for this type of investment. Experts indicate that it can take as long as seven to 10 years for residential U.S. homeowners to break even on this upgrade. I’m Bill Whitman, the founder of LearnExcel.io, where I combine my passion for education with my deep expertise in technology.

The disadvantage is that it requires a discount rate to be chosen, which may be subjective or uncertain, and that it is more complex and difficult to calculate. Since the concept helps compute payback period with the breakeven point, the investor can easily plan their financial strategies further and make more decisions regarding the next step. It is calculated by dividing the investment made by the cash flow received every year. This is a valuable metric for fund managers and analysts who use it to determine the feasibility of an investment. However, it is to be noted that the method does not take into account time value of money.