Payback method formula, example, explanation, advantages, disadvantages

payback period

This formula ignores values that arise after the payback period has been reached. In its simplest form, the calculation process consists of dividing the cost of the initial investment by the annual cash flows. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.

  • Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is met.
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  • In an Energy Conservation Option usually the annual money saving is only due to energy savings and hence it is the product of the energy saved and the price of energy.
  • To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize.
  • A shorter period means they can get their cash back sooner and invest it into something else.
  • Companies also use the payback period to select between different investment opportunities or to help them understand the risk-reward ratio of a given investment.

A shorter payback period helps limit the negative financial impact of adverse events like these. Payback period intuitively measures how long something takes to «pay for itself.» All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below. Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division. The payback period can help investors decide between different investments that may have a lot of similarities, as they’ll often want to choose the one that will pay back in the shortest amount of time. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

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The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years. The term is also widely used in other types of investment areas, often with respect 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. The decision rule using the payback period is to minimize the time taken for the return on investment. The Payback Period shows how long it takes for a business to recoup an investment.

  • Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities.
  • Payback Period is one of the techniques used to analyze whether a particular investment project should be accepted or rejected.
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  • In this metric, future cash flows are estimated and adjusted for the time value of money.
  • But in the case of unequal cash inflows the PB period can be found out by adding up the cash inflows until the total is equal to initial cash outlay.
  • If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly.

The payback period can be a valuable tool for analysis when used properly to determine whether a business should undertake a particular investment. However, this method does not take into account several key factors including the time value of money, any risk involved with the investment or financing. For this reason, it is suggested that corporations use this method in conjunction with others to help make sound decisions about their investments. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period.