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What Is a Payback Period? How Time Affects Investment Decisions

The predictability of cash flows must be known to get an accurate picture of when the initial investment can be recovered. Additional outlays of cash will need to be taken into account as well for maintenance, upgrades, and other miscellaneous costs. Since the PMP Exam is not an accounting exam, potential PMP credential holders are not usually https://simple-accounting.org/ required to use the payback period PMP formula to calculate the payback period for projects. Instead, the PMP exam focuses more on testing your conceptual knowledge. You will most likely not actually have to calculate the payback period for any question, but it is still a valuable resource to have in your project management toolkit.

This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). The equation does not calculate cash flows in the years past the point where the machine is expected to be paid off. It’s possible those cash flows will be higher than the previous years.

According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. This one is a measure of liquidity and tells you how long a project will take to recoup the initial amount invested in it. If an investment has a payback period of 7 years and the asset has a useful life of 6 years, the investment won’t have enough time to make its money back or strike a profit. The time value of money is not considered in the payback period calculation. These measures are related to profitability so adding a metric for liquidity adds another angle to the investment analysis.

  1. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below.
  2. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
  3. Anyone in the business world should be familiar with this universal business concept.
  4. These measures are related to profitability so adding a metric for liquidity adds another angle to the investment analysis.
  5. In summary, the payback period is a simple calculation that is easy to understand and provides valuable information.

The purchase of machine would be desirable if it promises a payback period of 5 years or less. If cash inflows from the project are even, then the payback period is calculated by taking the initial investment cost divided by the annual cash inflow. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project.

Capital Expenses

However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. Previously we mentioned that companies look for the shortest payback periods. This is so the money is not tied up for too long and management can reinvest it elsewhere, perhaps in additional equipment that will generate more profit. But what if the machine for Jimmy’s Jackets will no longer be profitable past 3 years?

Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. The sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.

CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. We serve content to help young professionals develop personally, professionally, and financially. As such, this website will cover a variety of topics aimed to help you have a successful life and career. Payback period must be looked at with awareness of the lifespan of an investment. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5.

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. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value straight line depreciation method definition, examples of money. There are two methods to calculate the payback period, and this depends on whether your expected cash inflows are even (constant) or uneven (changing every year). A large purchase like a machine would be a capital expense, the cost of which is allocated for in a company’s accounting over many years. No such adjustment for this is made in the payback period calculation, instead it assumes this is a one-time cost.

Payback Period Calculation Example

Payback period can be used complementary with other capital budgeting measures such as NPV, IRR, and cash on cash return to identify an investment’s attractiveness. Project A has a payback period of 2 years and Project B has a payback period of 5 years. Although the payback period will probably not be a heavily tested concept on the PMP exam, it is good baseline knowledge. Anyone in the business world should be familiar with this universal business concept. You are unlikely to be required to answer more than one or two questions on payback periods.

In this case, the initial investment does not matter for the answer, which eliminates options A and C. The correct answer is option D because shorter payback periods are considered more financially favorable. Company C is planning to undertake a project requiring initial investment of $105 million.

Discounted Payback

Payback period means the period of time that a project requires to recover the money invested in it. In the scenario of calculating a payback period, we are looking at projected returns on the investment over a number of months or years, and therefore disregarding what amount of interest could be made. Therefore, this might not give an accurate overall picture of what cash flows will actually be earned for the project. The above equation only works when the expected annual cash flow from the investment is the same from year to year. If the company expects an “uneven cash flow”, then that has to be taken into account. At that point, each year will need to be considered separately and then added up.

Let’s say Jimmy does buy the machine for $720,000 with net cash flow expected at $120,000 per year. The payback period calculation tells us it will take him 6 years to get his money back. When he does, the $720,000 he receives will not be equal to the original $720,000 he invested. This is because inflation over those 6 years will have decreased the value of the dollar. No such discount is allocated for in the payback period calculation.

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. A company may be tight on liquid assets or have plenty of liquidity. The reliability of the payback period measure is only as strong as its estimations and assumptions. Payback period is a valuable calculation for industries that are subject to projects quickly becoming obsolete.

The more information you have, the more accurate the payback period calculation will be and the more reliable of a measure it will be. It is a quick and dirty calculation to assess liquidity and risk of an investment. One can see how long money will be tied up in a project and if that length of time poses a risk. The answer results in a payback period of 2.75 years, which makes sense since the waterfall chart showed us that the initial investment was earned back between years 2 and 3. The table with the orange header lists out our net cash flows and cumulative net cash flows from year 0 to year 4.

Payback Period and Capital Budgeting

The project is expected to generate $25 million per year in net cash flows for 7 years. This payback period calculation only works when expected cash flows are the same from period to period. For example, this equation would work if a project expected to earn $90 each and every year after the initial outlay of $500. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. 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.

As a stand-alone tool to compare an investment to “doing nothing,” payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). In this article, we will explain the difference between the regular payback period and the discounted payback period. You will also learn the payback period formula and analyze a step-by-step example of calculations.

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