Select Page

The calculation
therefore requires the discounting of the cash flows using an interest or
discount rate. Assume that Company A has a project requiring an initial cash outlay of $3,000. The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%.

For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused indicators such as internal rate of return or return on investment. It can however also be leveraged to measure the success of an investment or project in hindsight and determine the point at which an initial investment has actually paid back.

  1. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project.
  2. As a result, the payback period may yield a positive result, whereas the discounted payback period yields a negative outcome.
  3. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.

The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. In real-life scenarios, depreciation is considered as it is unlikely an operating machine would remain optimal for an extended period.

It is calculated by taking a project’s future estimated cash flows and discounting them to the present value. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project. The payback period value is a popular metric because it’s easy to calculate and understand. However, it doesn’t take donation expense accounting entry into account money’s time value, which is the idea that a dollar today is worth more than a dollar in the future. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.

One way corporate financial analysts do this is with the payback period. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. In this example, the cumulative discounted
cash flow does not turn positive at all.

In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis. Option 1 has a discounted payback period of
5.07 years, option 3 of 4.65 years while with option 2, a recovery of the
investment is not achieved. One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year. In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. So, the two parts of the calculation (the cash flow and PV factor) are shown above.

The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. The payback period refers to how long it takes to reach that breakeven. The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method.

Discounted payback period

In other words, the investment will not be recovered
within the time horizon of this projection. The discounted payback period is a measure
of how long it takes until the cumulated discounted net cash flows offset the
initial investment https://intuit-payroll.org/ in an asset or a project. In other words, DPP is used to
calculate the period in which the initial investment is paid back. The payback period is the amount of time for a project to break even in cash collections using nominal dollars.

Sports & Health Calculators

This means that you would need to earn a return of at least 9.1% on your investment to break even. This means that you would need to earn a return of at least 19.6% on your investment to break even. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment.

But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period; however, they could have varying flows of cash. Payback period is the amount of time it takes to break even on an investment.

The company should therefore refrain from investing its funds in such project. The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost). Certain businesses have a payback cutoff which is essential to consider when proceeding with investment projects.

To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize. According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.

What Is the Formula for Payback Period in Excel?

In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures. The screenshot below shows that the time required to recover the initial $20 million cash outlay is estimated to be ~5.4 years under the discounted payback period method. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value.

Decision Rule

The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded. Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. Another advantage of this method is that it’s easy to calculate and understand. This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis.

Shape Calculators

One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total. Given a choice between two investments having similar returns, the one with shorter payback period should be chosen. Management might also set a target payback period beyond which projects are generally rejected due to high risk and uncertainty.

Discounted payback period calculation is a simple way to analyze an investment. One limitation is that it doesn’t take into account money’s time value. This means that it doesn’t consider that money today is worth more than money in the future. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20. If you’re discounting at a rate of 10%, your payback period would be 5 years. Discounted payback period refers to the number of years it takes for the present value of cash inflows to equal the initial investment.