Payback period is a financial or capital budgeting method that calculates the number of days required for an investment to produce cash flows equal to the original investment cost. In other words, it’s the amount of time it takes an investment to earn enough money to pay for itself or breakeven. This time-based measurement is particularly important to management for analyzing risk.
Definition: What is Payback Period?
Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment. In most cases, a longer payback period also means a less lucrative investment as well. Think about it in management’s terms. A shorter period means they can get their cash back sooner and invest it into something else. Thus, maximizing the number of investments using the same amount of cash. A longer period leaves cash tied up in investments without the ability to reinvest funds elsewhere.
Management uses the payback period calculation to decide what investments or projects to pursue.
The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.
As you can see, using this payback period calculator you a percentage as an answer. Multiply this percentage by 365 and you will arrive at the number of days it will take for the project or investment to earn enough cash to pay for itself.
Since some business projects don’t last an entire year and others are ongoing, you can supplement this equation for any income period. For example, you could use monthly, semi annual, or even two-year cash inflow periods. The cash inflows should be consistent with the length of the investment.
Let’s take a look at an example. Assume Jim’s Body Shop has $10,000 to invest into new equipment. Jim can either purchase new buffing wheel that will save labor hours and his crew from hand polishing the car finishes or he can purchase a bigger sand blaster that will be able to fit all his car parts in it thus getting rid of the need to outsource his sand blasting.
Jim estimates that the new buffing wheel will save 10 labor hours a week. Jim currently pays his finishing personnel $25 per hour. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. Here is how to calculate payback period for Jim’s Shop.
On the other hand, Jim could purchase the sand blaster and save $100 a week from without having to outsource his sand blasting.
Management uses the cash payback period equation to see how quickly they will get the company’s money back from an investment—the quicker the better. In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks. It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster.
Longer payback periods are not only more risky than shorter ones, they are also more uncertain. The longer it takes for an investment to earn cash inflows, the more likely it is that the investment will not breakeven or make a profit. Since most capital expansions and investments are based on estimates and future projections, there’s no real certainty as to what will happen to the income in the future. For instance, Jim’s buffer could break in 20 weeks and need repairs requiring even further investment costs. That’s why a shorter payback period is always preferred over a longer one. The more quickly the company can receive its initial cost in cash, the more acceptable and preferred the investment becomes.
Keep in mind that the cash payback period principle does not work with all types of investments like stocks and bonds equally as well as it does with capital investments. The main reason for this is it doesn’t take into consideration the time value of money. Theoretically, longer cash sits in the investment, the less it is worth. Money today is worth more than money tomorrow. In order to account for the time value of money, the discounted payback period must be used to discount the cash inflows of the project at the proper interest rate.