How to Calculate the Payback Period With Excel
The formula for the simple payback period and discounted variation are virtually identical. However, one common criticism of the simple payback period metric is that the time value https://www.wave-accounting.net/ of money is neglected. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive.
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. Since the PMP Exam is not an accounting exam, potential PMP credential holders are not usually required to use the payback period PMP formula to calculate the payback period for projects.
- Obviously, the longer it takes an investment to recoup its original cost, the more risky the investment.
- For example, if it takes five years to recover the cost of an investment, the payback period is five years.
- 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.
- This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects.
The payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period. You should also be familiar with the concepts and uses of return on investment, cost-benefit ratio, net present value, and other project selection concepts. The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow.
However, there are additional considerations that should be taken into account when performing the capital budgeting process. 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. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.
What is a Good Payback Period?
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 capital budgeting, the payback period is defined as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1.
Payback Period and Capital Budgeting
Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, business process automation meaning and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator.
Use Excel’s present value formula to calculate the present value of cash flows. 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.
Payback Period Example
The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money. It is the period of time that a project takes to generate cash flows when the cumulative present value of the cash flows equals the initial investment cost. 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.
It is based on a very simple need to get back at least how much has been spent. In fact, even as individuals when we invest in shares, mutual funds our first question is always about the time period within which we will get back our invested money. For more PMP exam guidance, get in touch with your experts at Project Management Academy or sign up for our online or in-person PMP certification training. We’re here to help you pass the PMP exam and accelerate your project management career.
For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years. In this case, the payback method does not provide a strong indication as to which project to choose. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. 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 shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. Using the averaging method, you should divide the annualized expected cash inflows into the expected initial expenditure for the asset. This approach works best when cash flows are expected to be steady in subsequent years.
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. Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. Although the payback period will probably not be a heavily tested concept on the PMP exam, it is good baseline knowledge. Anyone in the business world should be familiar with this universal business concept.
My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. According to this PMP technique, Project A is more likely to provide a financial benefit to your organization. If undertaken, the initial investment in the project will cost the company approximately $20 million.
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As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). From the finished output of the first example, we can see the answer comes out to 2.5 years (i.e., 2 years and 6 months). Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Save taxes with Clear by investing in tax saving mutual funds (ELSS) online. Our experts suggest the best funds and you can get high returns by investing directly or through SIP.
Due to its ease of use, payback period is a common method used to express return on investments, though it is important to note it does not account for the time value of money. As a result, payback period is best used in conjunction with other metrics. The second project will take less time to pay back, and the company’s earnings potential is greater.
