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Key Takeaways
- The payback period helps measure how quickly an investment can break even.
- Shorter payback periods generally indicate more attractive investments.
- The payback period is calculated by dividing the investment cost by the annual cash inflow.
- A key limitation is that the payback period ignores the time value of money.
What Is the Payback Period?
Individuals and corporations invest their money with the intention of getting it back and realizing a positive return. The shorter the payback, the more attractive an investment becomes. The payback period determines how long it will likely take for it to occur.
It’s the length of time before an investment reaches a breakeven point. Determining the payback period is a simple calculation.
Investopedia / Tara Anand
How the Payback Period Works
The payback period helps to determine how long it will take to recover the initial costs associated with an investment. You can calculate the payback period using this formula:
Payback Period=Average Annual Cash FlowCost of Investment
Average cash flows represent the money going into and out of an investment. Inflows refer to any amount that enters the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance.
Who Uses the Payback Period?
The payback period is commonly used by investors, financial professionals, and corporations to calculate investment returns.
Capital budgeting is a key activity in corporate finance. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. Corporate financial analysts do this with the payback period.
Calculating the payback period is useful in financial and capital budgeting, but this metric also has applications in other industries and for individuals. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
Important
Some analysts favor the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.
Payback Period and Capital Budgeting
The payback period ignores the time value of money (TVM), unlike other methods of capital budgeting. Money is worth more today than the same amount in the future because of the earning potential of the present money.
Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. It must include an opportunity cost if you pay an investor tomorrow. The TVM is a concept that assigns a value to this opportunity cost.
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. The payback period would be five years if it takes five years to recover the cost of an investment.
This period doesn’t account for what happens after payback occurs. It ignores an investment’s overall profitability. Many managers and investors prefer to use net present value (NPV) as a tool for making investment decisions for this reason. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period.
Payback Period Example
Assume Company A invests $1 million in a project that’s expected to save the company $250,000 each year. We arrive at a payback period of four years for this investment if we divide $1 million by $250,000
Consider another project that costs $200,000 with no associated cash savings that will make the company an incremental $100,000 each year for the next 20 years, totaling $2 million. The second project can make the company twice as much money, but how long will it take to pay the investment back?
Divide $200,000 by $100,000 to get two years: The second project will take less time to pay back, and the company’s earnings potential is greater, so the second project is a better investment based solely on the payback period method if the company wants to prioritize recapturing its capital investment as quickly as possible.
How Will I Use This in Real Life?
The shorter the payback, the more attractive the investment. Let’s say you’re contemplating installing solar panels on your home. The installation cost will be $5,000, and your savings will be $100 each month. The payback period indicates that it would therefore take you 4.2 years to break even.
This might seem like a long time, but it’s a pretty good payback period for this type of investment. Experts indicate that it can take as long as seven to 10 years for residential U.S. homeowners to break even on this upgrade.
What’s a Good Payback Period?
The best payback period is the shortest one possible. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as possible. Not all projects and investments have the same time horizon, however, so the shortest possible payback period should be nested within the larger context of that time horizon.
Is the Payback Period the Same As the Breakeven Point?
The two terms are related, but they’re not the same. The breakeven point is the price or value that an investment or project must rise to if you want to cover the initial costs or outlay. The payback period refers to how long it takes to reach that point.
Is a Higher Payback Period Better?
A higher payback period means that it will take longer to cover the initial investment. It’s usually better for a company to have a lower payback period because this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure it has to a potential loss.
What Are Some of the Downsides of Using the Payback Period?
The payback period calculation is a simple one. It doesn’t account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time.
The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. The simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment for this reason.
When Would a Company Use the Payback Period for Capital Budgeting?
The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money it’s laid out for the project. A short payback period may be more attractive than a longer-term investment that has a higher NPV if short-term cash flows are a concern.
The Bottom Line
The payback period is the length of time it will take to break even on an investment. The appropriate timeframe will vary depending on the type of project or investment and the expectations of those undertaking it.
Investors might use payback in conjunction with return on investment (ROI) to determine whether to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV.
