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What Is a Payback Period? Its Importance and How To Calculate It

JamesHarris by JamesHarris
February 25, 2022
in Business
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The payback period is a metric used in capital budgeting to measure the profitability of an investment. A project will become profitable once it has earned back the initial cost of the investment, and that period is its payback period. 

If it takes longer than expected for your company to recoup its costs, then you’ve made a poor capital budgeting decision. This article will look at how to calculate it and why it’s essential.

Table of Contents

  • What Is a Payback Period?
  • The Formula for Calculating Your Company’s Payback Period Is Relatively Simple:
  • Importance of the Payback Period
    • Following Are Some Pointers That Showcase Why the Payback Period Is Crucial in Any Organization.
  • Conclusion

What Is a Payback Period?

Capital budgeting is the process of evaluating an investment opportunity, usually long-term in nature, to determine whether further analysis is warranted. A capital budgeting project will have a positive cash flow – that is, revenue generated from the project will be greater than the costs involved with completing it. The two primary measurements companies use when deciding between different projects are the expected rate of return (or discount rate) and the payback period.

The payback period is a time frame within which your company expects its initial investment to break even and become profitable. In simple terms, The payback period in business refers to how long it takes to recover the initial investment in a project or activity. Just like depreciation, the payback period is an accounting technique that effectively discounts money spent in the past.

While there are multiple ways to calculate this number, they all do so by dividing the initial cost into smaller, more manageable chunks. For example, let’s say you’ve been approached with a potential capital budgeting project that will cost your company $500 to complete. This project will generate an additional $900 for your company in the first year alone. The following year, it brings in another $700 – and so on until the fifth year, when it becomes a money-maker bringing in around $1,000 annually after that.

Your company is most interested in a two-year payback period because the initial investment is relatively small. That time frame allows them ample time to recoup their costs before they start seeing any profits from the project. Your calculation might look something like this:

$500 / (1 – (1 / 1) + (1 / 2)) = $500 / .5 = $1,000

This means that it will take your company one year to earn back its initial investment. At this point, they are already earning an additional $900 per year from the project, for a total of $1900 in additional annual revenue. The second-year sees another $700 produced by this project – bringing your company’s cumulative earnings to around three times its original investment. After the fifth year, the payback period is complete, and your company can expect yearly profits of about 1k from this business idea.

As you can see, while two years sounds good on paper, several factors might make or break a given capital budgeting project. This is why it’s essential to understand the payback period in business alongside other financial metrics such as risk, depreciation, and cash flow.

The Formula for Calculating Your Company’s Payback Period Is Relatively Simple:

 

Payback Period = Net Present Value/Investment Required for Payback

The net present value (NPV) represents how much cash will be available at the end of X number of periods. At the same time, “investment required for payback” refers to how much money will be invested during those periods.

For example, if you’ve invested $100,000 over the past four years and expect those investments to generate $30,000 in cash now and $60,000 in three more years (NPV), your payback period is:

$30,000/$100,000 = 3.33 years or 2.77 years (rounding up)

The lower a company’s payback period – i.e., the faster it recovers its initial investment – the better its return on investment. This makes sense intuitively because generating a 5 percent return on an investment that takes one year requires a 20 percent return on an investment that takes two years, even though both investments have been generating returns for five periods.

In other words, the company that takes one year to recover its initial investment at 20 percent grows faster than the company that takes two years to recover its initial investment at 5 percent.

As with many things in business, there are exceptions to the rule regarding the payback period. Some companies use a payback period of over one year for short-term projects, while others may use less than one year for long-term projects. In either case, however, if a company’s return on net assets (RONA) increases over time, its managers should not be overly concerned about a marginally negative NPV since a positive RONA represents a healthy and growing business.

Importance of the Payback Period

Following Are Some Pointers That Showcase Why the Payback Period Is Crucial in Any Organization.

  1. It helps decide whether to go ahead with a project.
  2. The cost of capital can be reduced by computing the payback period so that the debt/equity ratio would increase, increasing the return on equity, return on assets, and the net present value of stocks/bonds.
  3. The risk associated with projects can be assessed by computing the payback period, as this is one of the common factors used for comparing risky investments.
  4. A company’s management should benchmark its performance vis-à-vis others’ performance within the industry through the computation of various ratios, including payback period, internal rate of return (IRR), net present value (NPV), etc.
  5. It helps decide the length of time for raising funds or obtaining loans.
  6. It quantifies the speed with which investment is recouping its cost and the length of time before it starts to generate benefits, making it possible to decide whether an asset should be continued or not.
  7. Banks also use this ratio while providing loans as a shorter payback period means the lesser risk for them. It becomes easier for them to recover their money if the borrower defaults on loan repayment.
  8. Financial managers can make effective decisions using this performance measure because they know at what rate their cash flow will grow after recovering the initial amount invested within a certain period.
  9. If NPV is positive, the investment is worthwhile; negative investment should be re-examined or dropped.
  10. It helps decide whether investments should be made for the short term or the long term depending on the payback period.
  11. The payback period can also compare various projects because ratios are expressed in the same periods.
  12. Since this ratio represents cash flow, it can help decide whether the proposed expenditure fits into an organization’s budget because it will lower it and improve its profitability and financial position.
  13. This ratio is valuable for computing the break-even point because the amount must be generated annually after recouping the initial investment.
  14. The investors can use this ratio to identify where the project is generating additional cash flows and where it is not to allocate more funds to the departments already generating positive cash flows.
  15. It provides a measure of how long an organization has to meet its debt repayments if it decides to finance a new investment through debt, as a more extended payback period means lower risk and less reliance on external funding sources.

The calculation for NPV relies on estimates, forecasts, and assumptions about variables such as interest rates and tax rates, future cash flows, and inflation rates—all things that can change over time. Because all of these factors affect the return on investment, the payback method offers a simple way of getting a snapshot of how well the investment is doing at any given time.

The payback period tells managers to what extent an investment has affected cash flows, either positively or negatively. If the payback period is four years, it means that by the end of year 4, sponsors will have recouped all their initial investments. This may not be enough time to generate sufficient returns for them because it does not consider the opportunity costs involved in tying up funds over long periods without giving them opportunities to earn better returns elsewhere.

The computation demands an estimate of cost(C) and revenue (R), equal for capital expenditure projects but quite distinct for other investments/expenditures, e.g., an advertising campaign that incurs only expenses.

Conclusion

When used correctly, taking more than merely time into consideration can help businesses make intelligent capital budgeting decisions that are genuinely beneficial over the long run of their operations. Your company may consider itself more flexible by picking two-year payoffs but knowing how inflation, market changes, and operation costs could impact your bottom line will allow you to make wiser decisions moving forward.

By understanding this concept along with others like the net present value calculation, you’ll have a much more complete picture of the projects lining up in front of you.

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