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.
Perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project, the payback period is a fundamental capital budgeting tool commonly used in corporate finance.
- Conceptually, what does the payback period represent?
- For what reasons is the payback period an important measure for corporate decision-making?
- Which formulas can be used to calculate the payback period?
- How does the discounted payback period differ from the standard payback period?
In This Article
Payback Period Definition
Conceptually, the payback period 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 and spending before generating sustainable profits), a significant portion of companies, especially those that are publicly traded, tend to be more short-term oriented and focus on meeting near-term upcoming revenue and earnings per share (EPS) targets set by equity analysts.
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 period of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs).
But as a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be.
This 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).
On the other hand, a longer payback period suggests that the investment capital is going to be tied up for an extensive period of time – thus, the project is relatively 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 formula for calculating the payback period consists of dividing the cost of the initial investment by the annual cash flows.
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 payback period 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 payback period would be 2 years ($400k ÷ $200k).
This means 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 payback period rarely comes out to be a precise, whole number, the more practical formula is as follows.
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.
Discounted Payback Period Method
One drawback to the payback period calculation is that it ignores the time value of money (i.e., the opportunity cost of receiving cash earlier causes it to be worth more). This is where the discounted payback period method comes in.
The discounted payback period, in theory, is a more accurate measure, since it accounts for the fact that a dollar today is more valuable than a dollar received in the future.
That being said, the importance of discounting the cash flows becomes far more pronounced when it comes to investments/projects with longer payback periods.
So, the discounted payback period also calculates the amount of time required to recover the initial cash outlay of an investment, but its formula uses the discounted value of the cash flows generated.
Excel Template Download
Now, we’re all set to go through an example calculation of the payback period. To get started, fill out the form to download the spreadsheet and follow along.
Payback Period Example Calculation
First, we’ll calculate the payback period under the non-discounted approach. The two assumptions are as follows.
- Initial Investment: $10mm
- Cash Flows Per Year: $4mm
Our payback period 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 third and final column (Payback Period) is the metric that we are working towards and the formula uses the “IF(AND)” function in Excel that performs the following two logical tests.
- 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 payback period is 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 Payback Period Example Calculation
Moving onto our second example of calculating the payback period, we’ll use the discounted approach this time around. The three model assumptions are as follows.
- Initial Investment: $20mm
- Cash Flows Per Year: $6mm
- Discount Rate: 10.0%
The payback period table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money.
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.