Payback Period Explained, With the Formula and How to Calculate It

What Is the Payback Period?

The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.

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.

Key Takeaways

The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point.
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.
Account and fund managers use the payback period to determine whether to go through with an investment.
One of the downsides of the payback period is that it disregards the time value of money.

Understanding the Payback Period

The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. It helps determine how long it takes to recover the initial costs associated with an investment. This metric is useful before making any decisions, especially when an investor needs to make a snap judgment about an investment venture.

You can figure out the payback period by using the following formula:

$\begin{aligned}\text{Payback Period}=\frac{\text{Cost of Investment}}{\text{Average Annual Cash Flow}}\end{aligned}$

The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it becomes. 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 9- 10 years for residential homeowners in the United States to break even on their investment.

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.

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.

Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance.

Payback Period and Capital Budgeting

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). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money.

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 and 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.

This period does not account for what happens after payback occurs. Therefore, it ignores an investment's overall profitability. 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.

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.

Example of Payback Period

Here's a hypothetical example to show how the payback period works. 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.

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 if the company wants to prioritize recapturing its capital investment as quickly as possible.

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 have the same time horizon, 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 project can be decades while the payback period on a construction project may be five years or less.

Is the Payback Period the Same Thing As the Break-Even 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.

Is a Higher Payback Period Better Than a Lower Payback Period?

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 Are Some of the Downsides of Using the Payback Period?

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 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 the 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.

The Bottom Line

Payback period is the amount of time it takes to break even on an investment. 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.