For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project. However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability.
A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. 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 the most thorough, balanced look into a project’s risk vs. reward, investors should combine a variety of these models. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
Understanding the Payback Period
Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The term is also widely used in other types of investment areas, often with respect payback equation to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.
Payback period is used not only in financial industries, but also by businesses to calculate the rate of return on any new asset or technology upgrade. For example, a small business owner could calculate the payback period of installing solar panels to determine if they’re a cost-effective option. Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment. In most cases, a longer payback period also means a less lucrative investment as well.
Example of the Payback Method
Calculating the payback period is also useful in financial forecasting, where you can use the net cash flow formula to determine how quickly you can recoup your initial investment. Whether you’re using accounting software in your business or are using a manual accounting system, you can easily calculate your payback period. 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. 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.
As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. These two calculations, although similar, may not return the same result due to the discounting of cash flows.
Understanding the Discounted Payback Period
It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster. Jim estimates that the new buffing wheel will save 10 labor hours a week. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks.
The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. 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.