Payback Period Learn How to Use & Calculate the Payback Period

Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows. The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. According to payback method, the project that promises a quick recovery of initial investment is considered desirable.

The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. The payback period is the amount of time for a project to break even in cash collections using nominal dollars.

• The purchase of machine would be desirable if it promises a payback period of 5 years or less.
• 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.
• Under payback method, an investment project is accepted or rejected on the basis of payback period.
• Suppose a company is considering whether to approve or reject a proposed project.
• This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment.

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. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments.

Discounted Payback Period Example Calculation

As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend. Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years.

Cumulative net cash flow is the sum of inflows to date, minus the initial outflow. The payback period is the expected number of years it will take for a company to recoup the towing invoice template cash it invested in a project. So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100).

How to Calculate Payback Period (Step-by-Step)

Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. Suppose a company is considering whether to approve or reject a proposed project. In this case, the payback period would be 4.0 years because 200,0000 divided by 50,000 is 4. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit.

What does payback period mean?

It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows.

Discounted payback period formula

The metric is used to evaluate the feasibility and profitability of a given project. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital.

The Payback Period shows how long it takes for a business to recoup an investment. This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

She has worked in multiple cities covering breaking news, politics, education, and more. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.