Payback Period Reference Library Business

how to work out payback period

The reinvestment rate refers to the company’s weighted average cost of capital or WACC. The WACC is the function of the weighted average of the cost of equity and the cost of debt. In some cases, the same project might have two internal rates of return, which can lead to ambiguity and confusion. Multiple internal rates of return occur when dealing with non-normal cash flows, also called unconventional or irregular cash flows. The point after breaking even is when the total of discounted cash inflows will exceed the initial cost. Depending on the nature of the investment and the time horizon, it may take a while for the project to return the invested capital, if at all.

What Is The Payback Period?

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. This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment. You can use it when analyzing different possibilities to invest your money and combine it with other tools, such as the net present value (NPV calculator) or internal rate of return metrics (IRR calculator). For example, a firm may decide to invest in an asset with an initial cost of $1 million. Over the next five years, the firm receives positive cash flows that diminish over time.

Irregular Cash Flow Each Year

Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months). The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. 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. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

how to work out payback period

When Would a Company Use the Payback Period for Capital Budgeting?

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. Below is a break down of subject weightings in the FMVA® financial analyst program.

  1. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
  2. 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.
  3. The term cash flow signifies the amount of money that an investment generates or consumes over a period of time.
  4. Below is a break down of subject weightings in the FMVA® financial analyst program.
  5. Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows.

How to calculate payback period with irregular cash flows

The discounted payback period determines the payback period using the time value of money. The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment.

how to work out payback period

It also assumes that the cash flow generated during the investment period is reinvested at the same rate, which is almost never the case. Hence, the best use case of IRR is when the investment being analyzed does not generate a lot of intermediate cash flows. This could prove problematic when dealing with multiple cash flows at different discount rates, for which the NPV would be more beneficial. A regularly used metric by managers to evaluate the viability of investments, the internal rate of return, or IRR, is the rate of return that makes a project worthwhile investing in. In the arsenal of corporate finance tools for capital budgeting, it’s worth seeing how it compares to other capital budgeting methods such as NPV, IRR, modified IRR, and profitability index. The modified payback model is presented as the year when the cumulative positive cash flows are greater than the total cash flows.

While the payback period shows us how long 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 best accounting software of 2021 in accordance with the decision rule in the payback method. 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.

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. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries.

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. The second project will take less time to pay back, and the company’s earnings potential is greater. Based solely unearned revenue and subscription revenue on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Many managers and investors thus prefer to use NPV as a tool for making investment decisions.

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