What is the Payback Period?
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.
- Conceptually, what does the payback period represent?
- For what reasons is the payback period an important measure for capital budgeting?
- Which formulas can be used to calculate the payback period?
- How does the discounted approach differ from the standard payback period?
Table of Contents
Payback Period – Capital Budgeting Metric
Perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project, the payback period is a fundamental capital budgeting tool in corporate finance.
Conceptually, the metric can be viewed as the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached, which is when the amount of revenue produced by the project is equal to the associated costs.
- The earlier the cash flows from a potential project can offset the initial investment, the greater the likelihood that the company or investor will proceed with pursuing the project.
- In contrast, the longer it takes for a project to “pay for itself”, the less attractive the project becomes as it implies reduced profitability.
While there certainly are exceptions (i.e., projects that necessitate significant time before generating sustainable profits), a large portion of companies – especially those that are publicly traded – tend to be more short-term oriented and focus on near-term revenue and earnings per share (EPS) targets.
For a public company, the share price of the company could falter if near-term sales or profitability goals are not met, as the market is unlikely to uphold the current valuation just because management claims to be operating with a longer-term horizon in mind.
Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role.
In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs).
Rules for Interpreting the Payback Period
- Shorter Duration → As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be – which is because the sooner the break-even point has been met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced).
- Longer Duration → A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period – thus, the project is illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater.
Payback Period Formula
In its simplest form, the calculation process consists of dividing the cost of the initial investment by the annual cash flows.
- Payback Period = Initial Investment / Cash Flow Per Year
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.
The essential question being answered from the calculation is:
- “Given the cost of opening up new store locations in different states, how long would it take for revenue from those new stores to pay back the entire amount of the investment?”
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.
- $400k ÷ $200k = 2 Years
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.
But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows.
- Payback Period = Years Before Break-Even + (Unrecovered Amount / Cash Flow in Recovery Year)
Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is met. In other words, it is the number of years the project remains unprofitable.
Next, the “Unrecovered Amount” represents the negative balance in the year preceding the year in which the cumulative net cash flow of the company exceeds zero.
And this amount is divided by the “Cash Flow in Recovery Year”, which is the amount of cash produced by the company in the year that the initial investment cost has been recovered and is now turning a profit.
Payback Period Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Payback Period Example Calculation
First, we’ll calculate the metric under the non-discounted approach using the two assumptions below.
- Initial Investment: $10mm
- Cash Flows Per Year: $4mm
Our table lists each of the years in the rows and then has three columns.
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.
Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year.
Hence, the cumulative cash flow for Year 1 is equal to ($6mm) since it adds the $4mm in cash flows for the current period to the negative $10mm net cash flow balance.
- The current year cumulative cash balance is less than zero
- The next year cumulative cash balance is greater than zero
If the two are true, that means the break-even occurs in between the two years – and therefore, the current year is selected.
But because there is likely a fractional period that we cannot neglect, we must divide the cumulative cash flow balance for the current year (negative sign in front) by the cash flow amount of the next year, which is then added to the current year from earlier.
The screenshot below shows the formula in Excel.
From the finished output of the first example, we can see the answer comes out to 2.5 years (i.e., 2 years and 6 months).
By the end of Year 2, the net cash balance is negative $2mm, and $4mm in cash flows will be generated in Year 3, so we add the two years that passed before the project became profitable, as well as the fractional period of 0.5 years ($2mm ÷ $4mm).
Discounted Method Example Calculation
Moving onto our second example, we’ll use the discounted approach this time around, i.e. accounts for the fact that a dollar today is more valuable than a dollar received in the future.
The three model assumptions are as follows.
- Initial Investment: $20mm
- Cash Flows Per Year: $6mm
- Discount Rate: 10.0%
Here, each cash flow is divided by “(1 + discount rate) ^ time period”. But other than this distinction, the calculation steps are the same as in the first example.
In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months).
The takeaway is that the company retrieves its initial investment in approximately four years and three months, accounting for the time value of money.