Payback Period Explained: Formula, Calculation and Importance Leave a comment

payback equation

Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). 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. Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it.

If you consume a lot of electricity, solar might only translate to a small reduction in your electricity costs, which means it could take longer for you to see a return on your investment. That’s why it’s important to think about your home’s energy efficiency before you consider solar panels — you can save money on energy and get a smaller solar panel system. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.

Calculating Payback Using the Subtraction Method

However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year. Using the new machine is expected to produce an additional $150,000 in cash flow each year that it’s in use. This means the amount of time it would take to recoup your initial investment would be more than six years. 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. If earnings will continue to increase, a longer payback period might be acceptable.

The payback period is the amount of time it would take for an investor to recover a project’s initial cost. Payback period is the time or period it will take to obtain the amount of initial investment invested on a given project or investment. The periods can be in months, quarters or years, but more often years are the most commonly used periods. In this article, we will explain the difference between the regular payback period and the discounted payback period. You will also learn the payback period formula and analyze a step-by-step example of calculations.

Use of Payback Period Formula

This could prove problematic when dealing with multiple cash flows at different discount rates, for which the NPV would be more beneficial. The modified payback model is presented as the year when the cumulative positive cash flows payback equation are greater than the total cash flows. It is used by small or medium companies that make relatively small investments with constant annual cash flows. This is a huge, but sometimes overlooked, factor in the solar payback period.

Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Others like to use it as an additional point of reference in a capital budgeting decision framework.

NPV Formula: How to Calculate Net Present Value

As a rule of thumb, the shorter the payback period, the better for an investment. The payback period is a simple and useful metric that shows the amount of time it takes for a project to break even. It is calculated by dividing the initial investment by the annual cash flow.

  • If you spent more money than you made, you’ll have a negative number for your answer.
  • However, the payback period calculation poses a noteworthy problem as it does not take into account the time value of money.
  • Its biggest attraction for accountants and small business owners comes from the ease of use.
  • Using the subtraction method, subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved.
  • Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM).
  • Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years.
  • 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.

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