The method is extremely pay back period meaning simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time. Payback period intuitively measures how long something takes to “pay for itself.” All else being equal, shorter payback periods are preferable to longer payback periods.
For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years. In this case, the payback method does not provide a strong indication as to which project to choose. The discounted payback period extends the concept of the payback period by considering the time value of money. Here, future cash inflows are discounted using a particular rate, reflecting their present value.
What Are the Advantages of Calculating the Payback Period?
Investments with longer payback periods are most risky than ones with shorter periods because there is no way to know how the future will pan out. A manager is more likely to purchase a machine that should pay for it self in 6 months, than something that will tie up company funds for 3 years. A shorter payback period reduces the company risk of inaccurate future projections of investment cash flow. 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.
This calculation allows investors to determine whether an investment decision makes sense financially and, hence, how much money it will take to reach the break-even point. The payback period method is particularly helpful to a company that is small and doesn’t have a large amount of investments in play. 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. Management uses the payback period calculation to decide what investments or projects to pursue.
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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. A payback period refers to the time it takes to earn back the cost of an investment. More specifically, it’s the length of time it takes a project to reach a break-even point. The breakeven point is the level at which the costs of production equal the revenue for a product or service. In summary, the payback period and its variant, the discounted payback period, serve as useful initial screenings for investment projects, focusing on liquidity risk.
- For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach.
- It is considered to be more economically efficient and its sustainability is considered to be more.
- There are some clear advantages and disadvantages of payback period calculations.
- 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).
- Whether you’re new to investing or already have a portfolio started, there are many tools available to help you be successful.
Payback Period Example
If one has a longer payback period than the other, it might not be the better option. In contrast, the payback period method looks at how much time it takes for a company to recoup its original investment and reach a certain level of profit. A payback period of three months indicates that it takes just three months to make enough money to recover the initial investment. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project. For example, a project cost is $ 20,000, and annual cash flows are uniform at $4,000 per annum, and the life of the asset acquire is 5 years, then the payback period reciprocal will be as follows.
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This time-based measurement is particularly important to management for analyzing risk. Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account. The time value of money is the idea that cash will be worth more in the future than it is worth today, due to the amount of interest that it can generate.