The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost.

- Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period.
- There are some clear advantages and disadvantages of payback period calculations.
- The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%.
- Project Beta shows a faster recovery of the initial investment, indicating a shorter payback period compared to Project Alpha.
- It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
- The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.

This blog post will unlock the power of Excel to make calculating your investment’s payback period straightforward and error-free. With our guidance, determining if or when an investment can become profitable becomes a less daunting task. Before you invest thousands in any asset, be sure you calculate your payback period. This means the amount of time it would take to recoup your initial investment would be more than six years. 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.

## Understanding the Payback Period

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. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.

## What does payback period mean?

At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project.

## Payback Period Explained, With the Formula and How to Calculate It

Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested.

Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive the beginner’s guide to effective cause marketing strategies asset gives business owners the information they need to make the right decision for their business. 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.

Some investments take time to bring in potentially higher cash inflows, but they will be overlooked when using the payback method alone. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows. 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. For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year. Assume that Company A has a project requiring an initial cash outlay of $3,000. The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%.

The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows. In capital budgeting, the payback period is defined https://simple-accounting.org/ as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment. Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows.

As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). 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. The sooner the break-even point is 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). 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. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism.

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. Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment. The payback period also facilitates side-by-side analysis of two competing projects.

All of the necessary inputs for our payback period calculation are shown below. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow. The shorter the payback period, the more likely the project will be accepted – all else being equal. Excel doesn’t have a dedicated “payback period” function, but you can use other functions like “CUMIPMT” or create a custom formula to find it.

This is when your project has paid itself off – that’s your payback period! If it doesn’t add up to a whole number, there will be a fraction of the year left over. Just add up each period’s cash flow with the total from previous periods to get this number. GoCardless helps businesses automate collection of both regular and one-off payments, while saving time and reducing costs. Find out how GoCardless can help you with ad hoc or recurring payments.

Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. In this case, the payback period would be 4.0 years because 200,0000 divided by 50,000 is 4. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded.

Based solely 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. In such situations, we will first take the difference between the year-end cash flow and the initial cost left to reduce. 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. After the initial purchase period (Year 0), the project generates $5 million in cash flows each year. The discounted payback period, in theory, is the more accurate measure, since fundamentally, a dollar today is worth more than a dollar received in the future.