Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.

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. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. Longer payback periods are not only more risky than shorter ones, they are also more uncertain.

The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. The payback period is the time it will take for your business to recoup invested funds. For instance, if your business was considering upgrading assembly line equipment, you would calculate the payback period to determine how long it would take to recoup the funds used to purchase the equipment.

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 laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay.

Understanding the Payback Period and How to Calculate It

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. 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. In most cases, this is a pretty good payback period as experts say it can take as much as 7 to 10 years for residential homeowners in the United States to break even on their investment.

Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments. The main reason for this is it doesn’t take into consideration the time value of money.

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. A shorter period means they can get their cash back sooner and invest it into something else. A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project. However, based solely on the payback period, the firm would select the first project over this alternative.

What Is the Formula for Payback Period in Excel?

The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. 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.

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. The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments.

Internal Rate of Return (IRR)

Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period with varying break-even points due to the varying flows of cash each project generates.

Calculating the Payback Period With Excel

1. Below is a break down of subject weightings in the FMVA® financial analyst program.
2. We’ll explain what the payback period is and provide you with the formula for calculating it.
3. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period.
4. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered.

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. The second project will take less time to pay customising your xero codes and chart of accounts back, and the company’s earnings potential is greater.

Payback Period (Payback Method)

If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. 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. 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.

Given its nature, the payback period is often used as an initial analysis that can be understood without much technical knowledge. It is easy to calculate and is often referred to as the “back of the envelope” calculation. Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter the payback an investment has, the more attractive it becomes.

While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment. That’s what the payback period calculation shows, adding up your yearly savings until the $400,000 investment has been recouped. 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. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. While the payback period shows us how long what happens if you overpay your credit card 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.

CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. Before you invest thousands in any asset, be sure you calculate your payback period. For example, if the building was purchased mid-year, the first year’s cash flow would be $36,000, while subsequent years would be $72,000. 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. Many managers and investors thus prefer to use NPV as a tool for making investment decisions.