A Payback period is a metric used to analyze the time taken for an investment to generate returns, which could be revenue or cost savings. It is also one of the most specific financial metrics that can help you answer a simple question – “will this project make sense to undertake?”
The Payback period helps you determine whether your proposed business venture will result in a net positive gain after considering all direct and indirect costs involved. The main objective is to determine if the benefits of undertaking a particular activity or buying a specific asset outweigh its charges in a particular time frame.
For instance, let’s say that you have just purchased a new laptop for your office for $3,000. Your CFO tells you that he can recover it in six months through savings in energy costs. However, you also know that the new laptop will reduce workforce requirements since it’s more efficient than the old system. So, your CFO determines that there would be $2,500 less paid to employees every month due to the reduced need for manual labor.
After considering all direct and indirect costs related to buying this asset (energy cost recovery plus monthly payroll) within one year, you realize that it’s not possible to recover its purchase price. Thus, the payback period doesn’t lie between 6 months and one year; hence, making it unproductive in this case study.
Although seemingly simple, computing payback periods can get complex if companies take into consideration intangible costs, like:
- Cost of capital (COC) and opportunity cost (OC)
- Tax benefits and depreciation charges
However, we will discuss these concepts in greater depth further ahead. For now, let’s focus on calculating the payback period using a straightforward formula.
How to Calculate a Payback Period?
To compute the payback period, you need to follow three steps:
Step 1: Determine your cash-in and cash-out transactions for a given time frame. This must include all costs and revenues associated with undertaking this project, such as the purchase price of an asset (and its salvage value), expenditure incurred in hiring additional employees, or revenue generated through the sale of goods or services.
Ideally, you should consider the net present value (NPV) method instead of taking cash inflow and outflow at face value. It gives a better insight into how much money would be available between now and when the investment returns. You can take advantage of software tools like Microsoft Excel to compute this. The NPV shows the total value of cash inflows minus cash outflows at a given time for an investment or business project.
If you are still not comfortable with numbers, simply take help from someone who has expertise in finance, accounting, or financial modeling. This will facilitate your decision-making process by giving you more accurate and reliable conclusions based on, like the payback period.
Step 2: Determine the rate of return (ROR) and the time frame over which this money is received/spent or invested/repaid. You need to determine how much money you expect to receive or spend, typically expressed as a percentage per year (ROR). For instance, if you invest $10,000 today, you should expect to receive $1,500 or 15% in annual returns after five years. The time frame over which this money is returned to you is typically the number of years these investments stay in your business.
Step 3: Now that you have two figures – cash inflow and ROR – plug them into the following formula to compute your payback period:
Payback Period = [Cash In]/ROR
Formula 1: How to Determine Payback Period Using First Principle (No Discounting)
The calculations get complicated if you factor in the time value of money, increased cost due to inflation, and tax benefits. One familiar pitfall companies make computing their payback periods is assuming that the cash flows are received at equal intervals. According to this concept, if you get your first payment three years after making the initial investment, you should count it as such and not include any previous receipts to get a correct payback period.
However, we will use simple arithmetic here and consider all costs and revenues over an extended time frame while computing our payback period. This would provide us with rough estimates based on which we can make decisions like buying or investing in a new business venture. Also, we won’t consider inflation and tax benefits because they affect the net present value (NPV) of future cash flows, which is often used for capital budgeting decisions [2].
Let’s look at how to determine the payback period using the following formula:
Formula 1: Payback Period = [Initial Investment]/ROR
For example, if one makes an initial investment of $10,000 and expects to receive $1,500 or 15% in annual returns every year for four years, then the payback period is computed as follows:
$10,000 / 0.15 = $66,666.67 (or simply 67) months or 5.2 years . The company will recover its entire original investment amount after five and a half years – at which point it should be able to start making a profit. It will continue incurring costs associated with the project, such as salaries for new employees or supplies used.
Here’s the calculation for your reference:
Formula 2: How to Determine Payback Period Using Second Principle (With Discounting)
This rule of thumb is often followed in business and finance because it lends itself to easy computation. However, computing the payback period using this equation ignores the time value of money, resulting in an inaccurate estimate. This happens because the future benefits are discounted at a higher rate than the initial investment resulting in more time being taken by companies to recover their costs.
Let us look at how you can compute the payback period using the following formula with discounting factor d :
Formula 2: Payback Period = [(1+r)/(1+d)]^ t * [Initial Investment]/ROR
Here’s an example of computing the payback period using this formula:
Let us assume that one invests $10,000 at 10% (ROR) compounded annually for five years. How long would it take them to recover their initial investment? This is how it will play out on paper:
$10,000 / 0.1 = $100,000 (or simply 100k) ([Initial Investment]/ROR) becomes Initial Investment divided by ROR. The number of periods t=5 if the payout occurs every year, so the calculation becomes [(1+r)/(1+d)]^t where r is the rate of return and d is your discounting factor which in this case is 0.1 or 10%.
The calculation comes out to be 66.74 months or five years and four months.
This means it will take almost six years to recover its initial investment amount at 10% compounded annually – or around five years if you do not factor in the time value of money. The payback period would have been shorter had one invested their money at a higher rate. Still, as we can see here, even a low discounting rate has a significant impact on determining the payback period because the future cash flows are discounted more steeply than the initial investment, so companies should use NPV instead for decisions like capital budgeting.
Formula 3: How to Determine Payback Period Using Future Values
Another way of computing the payback period is by using future values of annual returns. This method considers the time value of money calculates the number of years it will take for an investment to recover its initial cost. Therefore, this formula can be used when discounting factors are factored in or not. Let’s look at how you can determine the payback period using future values below:
Formula 3: Payback Period = [Initial Investment]/([(1+r)^n – 1]/r)
This means that if you need your money back after N years, then your next dollar earned should be discounted with the factor (1+r)^N – 1.
Here’s an example of computing the payback period using future values:
Let us assume that one invests $10,000 at 10% (ROR) compounded annually for five years. How long would it take them to recover their initial investment? This is how it will play out on paper:
$10,000 / ((1+0.1)5 – 1)/0.1 = 978 months or 83 years ([Initial Investment]/(((1+(R/100))^n-1)r) becomes Initial Investment divided by [( (1+(R/100))^n-1] times r). The number of periods t=5 if the payout occurs every year, so the calculation becomes [Initial Investment]/(((1+(R/100))^n-1)r).
The calculation comes out to be 83 years, waiting until the end of time, but you get the point.
The future values give a better estimate than using discounted cash flow since they factor in inflation and other internal rates of return, but doing this requires extensive knowledge with equations like Y = (C0+C1+…Cn)/( (1+i) ^ n ) where C is initial cash flow. I am discounting the rate over one period. This method works great when multiple periods are involved where investments will be made back at different times and can be used as an alternate for the internal rate of return.
Wrapping Up
There are numerous ways to calculate the payback period of a specific investment. You can either factor in time value or simply use the number of periods it will take to recoup your initial costs. There are too many formulas to choose from, so you should figure out which one works best for your needs and know the different types of payback calculations that can be used.
This way, you will save yourself from spending hours researching how to compute it and be able to accomplish your goals by finding the appropriate answer faster.