If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. If earnings will continue to increase, a longer payback period might be acceptable. If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly.
Shortcomings
The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future. For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs.
How Do You Calculate the Payback Period?
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). Quickonomics provides free access to education on economic topics to everyone around the world. Our mission is to empower people to make better decisions for their personal success and the benefit of society.
What Are the Advantages of Calculating the Payback Period?
- The payback period equation also doesn’t take into account the effects an investment might have on the rest of the company’s operations.
- By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform.
- Since some business projects don’t last an entire year and others are ongoing, you can supplement this equation for any income period.
- A payback period of three months indicates that it takes just three months to make enough money to recover the initial investment.
- If a project is large enough to require multiple phases, each phase may have a different payback period.
That’s why business owners and managers need to use capital budgeting techniques to determine which projects will deliver the best returns, and yield the most profitable outcome. This still has the limitation of not considering cash flows after the discounted payback period. Payback period is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to “doing nothing,” payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). The payback period is the amount of time it takes to break even on an investment.
In essence, the shorter the payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. Managerial accountants really have no idea what their investment is going to do in the future. They can estimate and predict what the future cash inflows will be, but there is no guarantee.
As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. Most capital budgeting formulas, such as net present value (NPV), internal pay back period meaning rate of return (IRR), and discounted cash flow, consider the TVM.
Why the Payback Period Matters
As per the assumptions used in this article, Powerwall’s payback ranged from 17 years to 26 years. Considering Tesla’s warranty is only limited to 10 years, the payback period higher than 10 years is not idea. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.