Payback Period Calculator
Results
Period Breakdown
| Period | Cash Flow | Discounted CF | Cumulative CF | Discounted Cumulative CF |
|---|
What is the Payback Period?
The Payback Period is a fundamental concept in capital budgeting that measures the time required for an investment to generate enough cash flow to recover its initial cost. In simpler terms, it answers the question: "How long will it take to get my money back?" It's a popular metric because of its simplicity and focus on liquidity and risk. A shorter payback period generally indicates a less risky investment, as the initial capital is recovered sooner.
Simple vs. Discounted Payback Period
There are two primary methods for calculating the payback period, each with its own advantages and disadvantages.
Simple Payback Period
This is the most straightforward method. It calculates the recovery time without considering the time value of money. It simply sums up the expected cash flows period by period until the initial investment is met.
- Pros: Easy to calculate and understand. Provides a quick measure of risk and liquidity.
- Cons: Ignores the time value of money (a dollar today is worth more than a dollar tomorrow). It also disregards any cash flows that occur after the payback period has been reached, potentially overlooking more profitable long-term projects.
Discounted Payback Period
This method is a more sophisticated approach that accounts for the time value of money. Before summing the cash flows, it discounts each future cash flow to its present value using a specified discount rate (often the company's cost of capital or required rate of return).
- Pros: Provides a more accurate picture of an investment's break-even point by incorporating risk and the opportunity cost of capital. It is considered a more financially sound metric than the simple payback period.
- Cons: Requires an additional input (the discount rate), which can be subjective. Like the simple method, it also ignores cash flows beyond the payback period.
How to Calculate the Payback Period
The calculation differs slightly for even and uneven cash flows.
Formula for Even Cash Flows
If an investment generates a constant cash flow each period, the formula is simple:
$$ \text{Simple Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}} $$
Calculation for Uneven Cash Flows
When cash flows are different each year, you must calculate the cumulative cash flow for each period. The payback period is the point at which the cumulative cash flow turns from negative to positive.
- Start with the initial investment as a negative number (cash outflow at Period 0).
- Add each period's cash inflow to the cumulative total from the previous period.
- Identify the last period with a negative cumulative cash flow (let's call this Period 'A').
- The payback period is then calculated by interpolating the final fraction of the year.
$$ \text{Payback Period} = A + \frac{\text{Cumulative Cash Flow at start of Period A (as a positive number)}}{\text{Cash Flow during Period (A+1)}} $$
For the Discounted Payback Period, you perform the same cumulative calculation, but only after first discounting each cash flow with the formula:
$$ \text{Discounted Cash Flow} = \frac{\text{Cash Flow}_t}{(1 + r)^t} $$
Where 'r' is the periodic discount rate and 't' is the period number.
Limitations of the Payback Period
While useful, the payback period should not be the sole factor in an investment decision due to its limitations:
- Ignores Profitability: The method's primary focus is on capital recovery time, not on the overall profitability of a project. A project with a short payback period might generate very little profit after it breaks even, while a project with a longer payback period could be vastly more profitable in the long run.
- Disregards Post-Payback Cash Flows: Any cash flows, positive or negative, occurring after the payback period are completely ignored. This is a significant drawback as it can lead to poor investment choices.
- Arbitrary Cutoff: Companies often set an arbitrary maximum acceptable payback period (e.g., 3 years). This can lead to the rejection of potentially valuable long-term strategic investments.
Because of these limitations, the payback period is best used in conjunction with other capital budgeting metrics like Net Present Value (NPV) and Internal Rate of Return (IRR).
Frequently Asked Questions (FAQ)
What is payback period?
The payback period is the time it takes for an investment to generate enough cash flow to recover its initial cost. It is a simple measure of how quickly an investment will pay for itself.
How is simple payback calculated?
Simple payback is calculated by dividing the initial investment by the annual cash inflow for even cash flows. For uneven cash flows, you track the cumulative cash flow year by year until the initial investment is recovered, interpolating for the final fractional year.
What is discounted payback?
The discounted payback period is similar to the simple payback period, but it takes into account the time value of money by discounting future cash flows back to their present value before calculating the recovery time.
Which payback method should I use?
The discounted payback period is generally considered superior because it accounts for the time value of money and project risk. However, the simple payback period is easier to calculate and is useful for a quick assessment of liquidity risk.
How do I input irregular cash flows?
Select the 'List of Cash Flows' input method. You can then add a row for each period and enter the specific cash flow amount for that period. You can also paste data from a spreadsheet.
What are the limitations of payback period?
The primary limitations are that it ignores cash flows that occur after the payback period and (in its simple form) ignores the time value of money. It is a measure of risk, not profitability.
