Define Payback Period
The payback period is the time it takes to earn back the cash invested in a project. It allows a business to determine how long it will take before a project will recover it’s original investment.
The simple payback period, is a useful tool for a business to compare projects. Using the payback period method, the business would choose the project which has the shortest cash payback period.
Payback Period Calculation
The payback period formula is as follows:
Payback Period Example
If a business invests in a project whose cost is 150,000 and expects to receive cash inflows of 32,000 per year, then the payback period is
Payback period = Cost of project / Annual cash inflows = 150,000 / 32,000 = 4.69 years.
It will take the business 4.69 years to recover the original investment of 150,000 in the project, as shown in the diagram below.
|Project Investment – 150|
|Year 1||Year 2||Year 3||Year 4||Year 5|
|+ 32||+ 32||+ 32||+ 32||+ 32|
|Payback Period = 4.69 years|
If the business had another project requiring investment of 200,000 with annual cash inflows of 53,000 per year, the payback period of this project would be
Pay back period = Cost of project / Annual cash inflows = 200,000 / 53,000 = 3.77 years.
Using the payback period method, the business would choose the second project as this has the shorter payback period.
Calculating Payback Period for Uneven Cash Flows
To calculate pay back period for uneven cash flows which vary from year to year, calculate the cumulative cash flow at the end of each year until the cumulative cash flow turns positive.
The cumulative cash flow turns positive in year 5, so the pay back period is somewhere between 3 and 4 years, depending on the timing of the final cash inflow of 53,000. At this point the cash inflows exceed the initial investment in the project of 160,000.
Advantages and Disadvantages of Payback Period
Advantages of Payback Period
- Simple to calculate and easy to understand
- Adjusts for uncertainty of later cash flows
- Biased towards liquidity as the quicker the investment in a project is returned the higher rank it will be given
Disadvantages of Payback Period
- Ignores the time value of money when calculating pay back
- Requires an arbitrary cutoff point
- Ignores cash flows beyond the pay back period
- Does not allow for any risk associated with the cash flows
Payback Period Calculator Download
We have produced a pay back period calculator to enable a business to calculate the pay back period of a project with uneven cash flows on entering the initial project cost and up to ten annual cash inflows.
The Excel pay back period calculator is available for download in Excel format by following the link below.