Payback Period definition, method, formula and examples

In such cases, the payback period is determined by cumulatively adding the cash inflows year by year until the sum equals or exceeds the initial investment. For example, consider a $100,000 investment with cash inflows of $30,000 in Year 1, $40,000 in Year 2, and $50,000 in Year 3. At the end of Year 2, cumulative cash flow is $70,000 ($30,000 + $40,000), leaving $30,000 ($100,000 – $70,000) yet to be recovered.

Calculating Payback Using the Averaging Method

A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y payback equation would cost $15,000.

What is Bad Payback Period?

Your discounted payback period is the amount of time it takes to reach the break even point on an investment by discounting future cash flows to adjust for the time value of money. The payback period is calculated by counting the number of years it takes for the cumulative cash inflows to equal the initial investment. A shorter payback period is generally preferable as it indicates less risk and faster recovery of investment. Longer payback periods are not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit.

• The payback period allows for comparison between various investment alternatives, helping to identify which project will return its initial cost most quickly.
• The payback period for this project would be calculated by dividing $100,000 by $25,000, resulting in a payback period of 4 years.
• Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value.
• In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven.
• The discounted payback period formula incorporates the present value of cash flows to provide a more accurate measure of investment recovery.

Fixed Cash Flow

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However, be sure to evaluate other factors alongside the payback period to ensure the investments make economic sense while also helping you stay true to your values. Investors can use the payback period to assess whether or not to make a certain investment. If someone isn’t going to get paid back in a reasonable timeframe, it can change their decision to make a particular investment. The subtraction method of the payback formula can help you assess an investment when cash flow is likely to vary from year to year. The Cumulative Cash Inflow column should be completed, showing the running total of cash inflow over the years. Now, the Cumulative Cash Inflow column is populated with the running total of cash inflow, allowing for calculating the payback period.

However, a https://sterlingmarketinggroup.com/functional-expense-schedule-best-practices-for-not/ shorter payback period doesn’t necessarily mean an investment will generate a high return or that it is risk-free. Additionally, if the payback period is longer than the expected useful life of the project, the investment is not profitable. It’s essential to consider other financial metrics in conjunction with payback period to get a clear picture of an investment’s profitability and risk. The first step in calculating the payback period is to gather some critical information. Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments.