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. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered.

How Do I Calculate a Discounted Payback Period in Excel?

Thus, at $250 a week, the buffer will have generated enough income (cash savings) to pay for itself in 40 weeks. Payback period is often used as an analysis tool because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to «doing nothing,» payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity). The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.

Cathy currently owns a small manufacturing business that produces 5,000 cashmere scarfs each year. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year. Using the new machine is expected to produce an additional $150,000 in cash flow each year that it’s in use. Alternative measures of «return» preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

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The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. For example, a firm may decide to invest in an asset with an initial cost of $1 million.

1. The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns.
2. The simple payback period formula is calculated by dividing the cost of the project or investment by its annual cash inflows.
3. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows.
4. Payback period means the period of time that a project requires to recover the money invested in it.

Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment bookkeeping services tempe az has paid for itself. If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can’t be applied.

Understanding the Payback Period

The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment.

A modified variant of this method is the discounted payback method which considers the time value of money. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. 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). Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay.

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. According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years.

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

The cash inflows should be consistent with the length of the investment. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. Are you still undecided about investing in new machinery for your manufacturing business? Perhaps you’re torn between two investments and want to know which one can be recouped faster?

Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value. Under payback method, an investment project is accepted or rejected on the basis of payback period.

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. Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the business consulting business plan purchase of that big-ticket asset, or hold off until your cash flow is better.

In essence, the shorter the payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.