Why 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.

While the two terms are related, they are not the same. The break-even 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. 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. 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. Harvard Business Review. Financial Analysis. Tools for Fundamental Analysis. Corporate Finance. Technical Analysis Basic Education.

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The payback period is the amount of time required for cash inflows generated by a project to offset its initial cash outflow.

This calculation is useful for risk reduction analysis, since a project that generates a quick return is less risky than one that generates the same return over a longer period of time. There are two ways to calculate the payback period, which are described below. 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. Subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved.

This approach works best when cash flows are expected to vary in subsequent years. For enterprise. This is the basic principle behind the payback period.

Learn more about how to calculate payback period, and what it means for your investments, below. The shorter the payback period, the more attractive the investment would be, because this means it would take less time to break even.

Payback period is used not only in financial industries, but also by businesses to calculate the rate of return on any new asset or technology upgrade. 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.

The resulting number is expressed in years or fractions of years. Written out as a formula, the payback period calculation could also look like this:. In this case, the payback period would be 4. There are some clear advantages and disadvantages of payback period calculations. Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment. 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. This can be a problem for investors choosing between two projects on the basis of the payback period alone.