Payback Period: Definition, Formula, and Calculation

Industries need to improve their energy efficiency due to environmental legislation and global competition. We help industries reduce their ecological footprint and energy bills by eliminating energy waste in a smart and simple way, allowing plant managers to focus on their production. If one investment is recouped faster than another, this can make it more attractive. Investors might also choose to add depreciation and taxes into the equation, to account for any lost value of an investment over time. For the most thorough, balanced look into a project’s risk vs. reward, investors should combine a variety of these models.

1. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project.
2. In most cases, this is a pretty good payback period as experts say it can take as much as 7 to 10 years for residential homeowners in the United States to break even on their investment.
3. However, based solely on the payback period, the firm would select the first project over this alternative.
4. The CAC Ratio is a more visual representation of the return you’re getting on each new customer.
5. Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow.

Why is it important to calculate your payback period?

When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. A shorter payback period means that the investment is generating cash flow more quickly, which can free up funds for other investments or allow the business to start earning a profit sooner. Additionally, a shorter payback period can reduce the risk of the investment since the business is able to recoup its costs more quickly. The payback period is a widely used approach by investors, financial experts, and corporations to compute investment returns.

Companies also use the payback period to select between different investment opportunities or to help them understand the risk-reward ratio of a given investment. The payback period can apply to personal investments such as solar panels or property maintenance, or investments in equipment or other assets that a company might consider acquiring. Often an investment that requires a large amount of capital upfront generates steady or increasing returns over time, although there is also some risk that the returns won’t turn out as hoped or predicted. Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division. As the equation above shows, the payback period calculation is a simple one. 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 payback period is used to evaluate the speed of an investment’s return and can be useful in comparing different investment opportunities. The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.

How do you break down the variables used to calculate payback period?

Promoting technical support, training or paid-for research represent other new revenue streams. Anything that increases a customer’s spend will see their payback period reduce. Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV. Other metrics, such as the internal rate of return (IRR), profitability index (PI), net present value (NPV), and effective annual annuity (EAA) can also be used to quantify the profitability of a given project. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize.

What is the payback period formula?

To calculate the payback period, you need to determine how long it will take for the investment to pay for itself. You can do this by dividing the initial investment by the annual cash flow generated by the investment. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period. Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero.

In essence, the shorter the 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. The payback period in capital budgeting is the amount of time it takes for your company to recover the cost of acquiring one customer. For example, a customer that costs $350 to acquire and contributes $25/month, or $300/year, has a payback period of 13.9 months. As time increases, a customer pays back more of the costs it took to acquire them in the first place – their customer acquisition cost (CAC) – through their incremental subscription payments.

1. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation.
2. Typically, payback period is calculated across a whole business, by totaling all customer acquisition costs in a period, and dividing by revenue contributed by new customers for the following period.
3. The payback period also facilitates side-by-side analysis of two competing projects.
4. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize.
5. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.

If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. The Payback Period shows how long it takes for a business to recoup an investment. 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. Prior to calculating the payback period of a particular investment, one might consider what their maximum payback period would be to move forward with the investment.

Energy-saving measure with a payback period of 0 days

Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. When you access this website or use any of our mobile applications we may automatically collect information such as standard details and identifiers for statistics or marketing purposes. You can consent to processing for these purposes configuring your preferences below. If you prefer to opt out, you can alternatively choose to refuse consent. Please note that some information might still be retained by your browser as it’s required for the site to function.

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. For businesses, payback period can serve as a useful way to see how viable a project is.

If, for example, you have a factory that produces products, then investing in a new machine can ensure that sales, and therefore turnover, are increased. The inflation rate for consumer pay back period meaning prices in the United States, according to the Bureau of Labor Statistics in June 2024. Investors should consider the diminishing value of money when planning future investments.