What Is the Payback Period?
The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.
- The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven.
- Account and fund managers use the payback period to determine whether to go through with an investment.
- Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.
- The payback period is calculated by dividing the amount of the investment by the annual cash flow.
Understanding the Payback Period
Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
Capital budgeting is a key activity in corporate finance. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period.
The payback period is the cost of the investment divided by the annual cash flow. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is. 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.
Capital Budgeting and the Payback Period
But there is one problem with the payback period calculation: Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM)—the idea that money today is worth more than the same amount in the future because of the present money's earning potential.
Most capital budgeting formulas—such as net present value (NPV), internal rate of return (IRR), and discounted cash flow—consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost. The TVM is a concept that assigns a value to this opportunity cost.
The payback period disregards the time value of money. It is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years. Some analysts favor the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.
The payback period does not account for what happens after payback, ignoring the overall profitability of an investment. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time.
Investors and money managers can use the payback period to make quick judgments about their investments.
Example of Payback Period
Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. The payback period for this investment is four years—dividing $1 million by $250,000. Consider another project that costs $200,000 with no associated cash savings that will make the company an incremental $100,000 each year for the next 20 years at $2 million.
Clearly, the second project can make the company twice as much money, but how long will it take to pay the investment back?
The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back and the company's earnings potential is greater. Based solely on the payback period method, the second project is a better investment.
Frequently Asked Questions
What is a good payback period?
The best payback period is the shortest one possible. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments will have the same time horizon, and so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement can be decades while the payback period on a construction project maybe 5 years or less.
Is the payback period the same thing as the breakeven point?
While the two terms are related they are not the same. 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.
How do you calculate the payback period?
Payback Period = Initial investment / Cash flow per year
What are some weaknesses of using payback period?
As the equation above shows, the payback period calculation is simple. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. The discounted payback period is often used to better account for some of the shortcomings such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
When would a company use payback period for capital budgeting?
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.