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

payback period formula

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows.

payback period formula

If earnings will continue to increase, a longer payback period might be acceptable. If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly. On the other hand, an investment with a short lifespan could need replacement shortly after its payback period, making it a potentially poor investment. 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.

Payback period

Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account. The time value of money is the idea that cash will be worth more in the Specialized Tax Services STS accounting method: PwC future than it is worth today, due to the amount of interest that it can generate. This is another reason that a shorter payback period makes for a more attractive investment.

The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000. Under the terms of the licence agreement, an individual user may print out a PDF Best Law Firm Accounting Software in 2023 of a single entry from a reference work in OR for personal use (for details see Privacy Policy and Legal Notice). Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months). In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5.

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By the end of Year 3 the cumulative cash flow is still negative at £-200,000. However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000.

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Downsides of Using the Payback Period

If the two are true, that means the break-even occurs in between the two years – and therefore, the current year is selected. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. We’ll now move to a modeling exercise, which you can access by filling out the form below. Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is met.

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