The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment. The payback period also facilitates side-by-side analysis of two competing projects.
Investments with higher cash flows toward the end of their lives will have greater discounting. For instance, a $2,000 investment at the start of the first year that returns $1,500 after the first year and $500 at the end of the second year has a two-year payback period. As a rule of thumb, the shorter the payback period, the better for an investment. Any investments https://www.bookstime.com/articles/what-is-fund-accounting with longer payback periods are generally not as enticing. 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.
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The payback period doesn’t take into consideration other ways an investment might bring value, such as partnerships or brand awareness. This can result in investors overlooking the long-term benefits of the investment since they’re too focused on short-term simple payback period formula ROI. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years.
- If earnings will continue to increase, a longer payback period might be acceptable.
- The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years).
- Payback period is a quick and easy way to assess investment opportunities and risk, but instead of a break-even analysis’s units, payback period is expressed in years.
- In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one.
- Average cash flows represent the money going into and out of the investment.
The main reason for this is it doesn’t take into consideration the time value of money. In order to account for the time value of money, the discounted payback period must be used to discount the cash inflows of the project at the proper interest rate. In simple terms, the payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash flow is positive, which is the payback year. According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. 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.