What is a Payback Period?
The payback period is the amount of time it will take to recoup the initial cost of an investment, or to reach its break-even point. This is one of the most important calculations for investors when planning investments and returns. It can help investors decide between different investments that may have a lot of similarities, as they’ll often want to choose the one that will pay back in the shortest amount of time.
The longer money remains locked up in an investment without earning a return, the more time an investor must wait until they can access that cash again, and the more risk there is of losing the initial investment capital.
There are several different ways that investments make money, from income to dividends to capital appreciation. Knowing how to find payback periods can help you understand whether an investment makes sense.
Using the Payback Period
The payback period can apply to personal investments such as solar panels or property maintenance, or investments in equipment or other assets that a company might consider acquiring. Often, an investment that requires a large amount of capital upfront generates steady or increasing returns over time, although there is also some risk that the returns won’t turn out as hoped or predicted.
Calculating payback periods is especially important for startup companies with limited capital that want to be sure they can recoup their money without going out of business. Companies also use the payback period to select between different investment opportunities or to help them understand the risk-reward ratio of a given investment.
Knowing the payback period is helpful if there’s a risk of a project ending in the future. For example, if a company might lose a lease or a contract, the sooner they can recoup any investments they’re making into their business the less risk they have of losing that capital.
Any particular project or investment can have a short or long payback period. A short period means the investment breaks even or gets paid back in a relatively short amount of time by the cash flow generated by the investment, whereas a long period means the investment takes longer to recoup. How investors understand that period will depend on their time horizon.
How to Calculate the Payback Period
Prior to calculating the payback period of a particular investment, one might consider what their maximum payback period would be to move forward with the investment. This will help give them some parameters to work with when making investment decisions. If the calculated payback period is less than the desired period, this may be a safer investment.
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. Payback period is generally expressed in years.
There are two easy basis payback period formulas:
Payback Period Formula – Averaging Method
Payback Period = Initial Investment / Yearly Cash Flow
Using the averaging method, the initial amount of the investment is divided by annualized cash flows an investment is projected to generate. This works well if cash flows are predictable or expected to be consistent over time, but otherwise this method may not be very accurate.
For example: If a company makes an investment of $1,000,000 in new equipment which is expected to generate $250,000 in revenue per year, the calculation would be:
$1,000,000 / $250,000 = 4-year payback period
If they have another option to invest $1,000,000 into equipment which they expect to generate $280,000 in revenue per year, the calculation would be:
$1,000,000 / $280,000 = 3.57-year payback period
Since the second option has a shorter payback period, this may be a better choice for the company.
Payback Formula – Subtraction Method
Payback Period = the last year with negative cash flow + (Amount of cash flow at the end of that year / Cash flow during the year after that year)
Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division. This method works better if cash flows vary from year to year.
For example: A company is considering making a $550,000 investment in new equipment. The expected cash flows are as follows:
Year 2 = $140,000
Year 3 = $200,000
Year 4 = $110,000
Year 5 = $60,000
Year 1 : -$550,000 + $75,000 = -$475,000
Year 2 : -$475,000 + $140,000 = -$335,000
Year 3 : -$335,000 + $200,000 = -$135,000
Year 4 : -$135,000 + $110,000 = -$25,000
Year 5 : -$25,000 + $60,000 = $35,000
Year 4 is the last year with negative cash flow, so the payback period equation is:
4 + ($25,000 / $60,000) = 4.42
So the payback period is 4.42 years.
Investors might also choose to add depreciation and taxes into the equation, to account for any lost value of an investment over time.
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Benefits of Using the Payback Period
The payback period is simple to understand and calculate. It can provide individuals and companies with valuable insights into potential investments, and help them decide which option provides the best return on investment (ROI). It also helps with assessing the risk of different investments. Advantages include:
• Easily understandable
• Simple to calculate
• Tool for risk assessment
• Helps with comparing and choosing investment options
• Provides insights for financial planning
• Other calculations, such as net present value and internal rate of return, don’t
• look at the amount of time it takes to recoup an investment
Downsides of Using the Payback Period
Although the payback period can be a useful calculation for individuals and companies considering and comparing investments, it has some downsides. The calculation only looks at the time period up until the initial investment will be recouped. It doesn’t consider the earnings the investment will bring in after that, which may either be higher or lower, and could determine whether it makes sense as a long-term 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. On the other hand, an investment with a short lifespan could need replacement shortly after its payback period, making it a potentially poor investment.
The payback period doesn’t take into consideration other ways an investment might bring value, such as partnerships or brand awareness. This can result in investors overlooking the long-term benefits of the investment since they’re too focused on short-term ROI.
The payback period equation also doesn’t take into account the effects an investment might have on the rest of the company’s operations. For instance, new equipment might require a significant amount of expensive power, or might not be able to run as often as it would need to in order to reach the payback goal.
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. Not only does this apply to the initial capital put into an investment, but it’s also important because as an investment generates returns, that cash can then be reinvested into something else that earns interest or income. This is another reason that a shorter payback period makes for a more attractive investment.
You can use the payback period in your own life when making large purchase decisions and consider their opportunity cost. Understanding the way that companies calculate their payback period is also helpful to determine their financial viability and whether it makes sense for you to invest in them as part of your portfolio.
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