There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. The payback period refers to how long it takes to reach that breakeven.
Input the known values (year, cash flows, and discount rate) in their respective cells. Use Excel's present value formula to calculate the present value of cash flows. Although it is simple outsourcing inventory management to calculate, the payback period method has several shortcomings. Suppose that in addition to the embroidery machine, Sam’s is considering several other projects.
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. The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.
Calculating the Payback Period
Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method.
The cash flow balance in year zero is negative as it marks the initial outlay of capital. 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. Payback period is a financial or capital budgeting method that calculates the number of days required for an investment to produce cash flows equal to the original investment cost. In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven. This time-based measurement is particularly important to management for analyzing risk.
- 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.
- This time-based measurement is particularly important to management for analyzing risk.
- Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive.
- Sam’s Sporting Goods is expecting its cash inflow to increase by $16,000 over the first four years of using the embroidery machine.
As you can see, using this payback period calculator you a percentage as an answer. Multiply this percentage by 365 and you will arrive at the number of days it will take for the project or investment to earn enough cash to pay for itself. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment. Average cash flows represent the money going into and out of the investment.
Is the Payback Period the Same Thing As the Breakeven Point?
Projects with longer payback periods than the length of time the company has chosen will be rejected. If Sam’s were to set a payback period of four years, Project A would be accepted, but Projects B, C, and D have payback periods of five years and so would be rejected. Sam’s choice of a payback period of four years would be arbitrary; it is not grounded in any financial reasoning or theory. No argument exists for a company to use a payback period of three, four, five, or any other number of years as its criterion for accepting projects.
Comparison of two or more alternatives – choosing from several alternative projects:
After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
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. Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased. 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 payback period is the time it will take for your business to recoup invested funds. Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment. In most cases, a longer payback period also means a less lucrative investment as well.
On the other hand, Jim could purchase the sand blaster and save $100 a week from without having to outsource his sand blasting. 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). If the two are true, that means the break-even occurs in between the two years – and therefore, the current year is selected. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. We’ll now move to a modeling exercise, which you can access by filling out the form below.
Payback period means the period of time that a project requires to recover the money invested in it. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it's usually better for a company to have a lower payback period as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
Payback Period Calculation Example
Jim estimates that the new buffing wheel will save 10 labor hours a week. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows. As a general rule of thumb, governmental accounting fund types the shorter the payback period, the more attractive the investment, and the better off the company would be. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects.
That’s why a shorter payback period is always preferred over a longer one. The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes. The discounted payback period is the number of years it takes to pay back the initial investment after discounting cash flows. In Excel, create a cell for the discounted rate and columns for the year, cash flows, the present value of the cash flows, and the cumulative cash flow balance.