On the other hand, payback period calculations can be so quick and easy that they’re overly simplistic. The payback period is the amount of time it would take for an investor to recover a project’s initial cost. 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.
- There are two ways to calculate the payback period, which are described below.
- WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted.
- Therefore, it would be more practical to consider the time value of money when deciding which projects to approve (or reject) – which is where the discounted payback period variation comes in.
- Next, we divide the number by the year-end cash flow in order to get the percentage of the time period left over after the project has been paid back.
- These two calculations, although similar, may not return the same result due to the discounting of cash flows.
As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). We’ll now move to a modeling exercise, which you can access by filling out the form below. But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows. 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. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism.
How do you calculate the payback period?
Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects. For lower return projects, management will only accept the project if the risk is low which means payback period must be short. Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods.
To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value liquidity in small business function and a table in a spreadsheet program. By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform.
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In this case, the payback period would be 4 years because 200,0000 divided by 50,000 is 4. You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one. Generally, a long payback period is determined by your own comfort level – as long as you are paying off one investment, you’ll be less able to invest in newer, promising opportunities. A higher payback period means it will take longer for a company to cover its initial 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.
Formula
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. Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash. Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential.
Understanding Discounted Payback Period
By forecasting free cash flows into the future, it is then possible to use the XIRR function in Excel to determine what discount rate sets the Net Present Value of the project to zero (the definition of IRR). By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000. Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment.
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. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects.
According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less. To determine how to calculate payback period in practice, you simply divide the initial cash outlay of a project by the amount of net cash inflow that the project generates each year.
The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.