Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year. The standard payback period is simply the amount of time an investment takes to recoup the initial cost. It can be calculated by dividing the initial investment cost by the annual net cash flow generated by that investment. 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.

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1. Because you pay on a subscription model with us, there are no purchase costs.
2. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period.
3. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability.
4. A lower payback period isn’t always better if it comes at the expense of other important considerations like risk, profitability, or long-term growth potential.
5. The discounted payback period is the procedure used to determine the profitability of a certain project or an investment.
6. By aggregating them all together, you can skew the calculation and get a misleading measurement.

The payback period can help investors decide between different investments that may have a lot of similarities, as they’ll often want to choose the one that will pay back in the shortest amount of 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. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even.

The payback period also facilitates side-by-side analysis of two competing projects. If one has a longer payback period than the other, it might not be the better option. To determine how to calculate payback period in practice, you simply divide the initial cash outlay of a project by the amount of net cash inflow that the project generates each year. For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year.

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. The discounted payback period is the procedure used to determine the profitability of a certain project or an investment. By calculating discounted payback period, you learn how many years it will take to earn profit from the initial investment.

IRR or internal rate of return is a financial metric used to determine the profitability of certain business investments. Most broadly speaking, the higher the IRR, the more desirable the investment opportunity is. IRR is calculated using the same formula as the net present value (NPV). Typically, payback period is calculated across a whole business, by totaling all customer acquisition costs in a period, and dividing by revenue contributed by new customers for the following period.

What are the drawbacks of using the payback period?

The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even. This means that it would take 2.5 years for the additional cash flow generated by the investment to equal the initial investment of $50,000. After that point, the investment would start to generate positive returns.

If cash inflows from the project are even, then the payback period is calculated by taking the initial investment cost divided by the annual cash inflow. In general, a shorter payback period is considered better, as it indicates that the investment will generate a positive return more quickly. However, what is considered a “good” payback period will depend on the goals of the investor and the nature of the investment. For example, a long-term investment with a high degree of risk may have a longer payback period but could still be a good investment if it has the potential for substantial returns over time. Ultimately, the appropriate payback period will depend on the specific investment and the goals of the investor. The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project.

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

1. Whether individuals or corporations, investors invest their money intending to receive returns on their investments.
2. This means that it would take 2.5 years for the additional cash flow generated by the investment to equal the initial investment of $50,000.
3. The metric is used to evaluate the feasibility and profitability of a given project.
4. After all, as the payback period gets longer, the probability of something happening in the meantime increases.
5. This financial metric is particularly valuable for making quick decisions about investment opportunities.
6. The cheaper you can get customers, the faster you should get a profit from them.

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 (net present value). While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method.

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Discounted Payback Period Calculation Analysis

The payback period is important in many different sectors, but it is especially popular in the energy sector. Almost all energy-saving measures have their cost savings calculated in advance. Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime.

In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs). There are two methods to calculate the payback period, and this depends on whether your expected cash inflows are even (constant) or uneven (changing every year). In order to determine whether the payback period is favourable or not, management will determine the maximum desired payback period to recover the initial investment costs. You could, of course, use annualised figures to calculate the payback period. The payback method is best suited for investments with a constant cash flow. Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period.

Efficient pay back period meaning companies are closer to 5 months (or less), while companies lower-performing companies are closer to the 12 month timeframe for payback. A payback period is the amount of time needed to earn back the cost of an investment. Sensorfact’s technology has a payback period of 0 days because we use a subscription model.

You can easily buy and sell with just a few clicks on your phone, and view your portfolio on one simple dashboard. In this case, the payback period would be 4.0 years because 200,0000 divided by 50,000 is 4. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach.