The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment.

A modified variant of this method is the discounted payback method which considers the time value of money. Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking.

This is an especially good rule to follow when you must choose between one or more projects or investments. The reason for this is because the longer cash is tied up, the less chance there is for you to invest elsewhere, and grow as a business. Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash.

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 tax deductions for donating office space to a nonprofit provide a strong indication as to which project to choose. 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.

This can be a problem for investors choosing between two projects on the basis of the payback period alone. One project might be paid back faster, but – in the long run – that doesn’t necessarily make it more profitable than the second. Some investments take time to bring in potentially higher cash inflows, but they will be overlooked when using the payback method alone.

A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. They can use that returned money sooner for other projects or opportunities. Then, you must calculate accumulated cash flow for each period until you break even. Remember to use absolute values by applying the “ABS” function where needed to avoid negative numbers creating confusion in your financial modeling. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.

- This can be done using the present value function and a table in a spreadsheet program.
- It is easy to calculate and is often referred to as the “back of the envelope” calculation.
- 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.
- But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions.

If you’ve ever found yourself in this situation, trying to figure out how quickly an investment will pay for itself, then understanding how to calculate the payback period in Excel is crucial. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. 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. So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100).

Before you invest thousands in any asset, be sure you calculate your payback period. This means the amount of time it would take to recoup your initial investment would be more than six years. Ideally, businesses would pursue all projects and opportunities that hold potential profit and enhance their shareholder’s value. However, there’s a limit to the amount of capital and money available for companies to invest in new projects. The situation gets a bit more complicated if you’d like to consider the time value of money formula (see time value of money calculator).

## Inputting data into Excel

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. Cumulative net cash flow is the sum of inflows to date, minus the initial outflow. In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples. GoCardless helps businesses automate collection of both regular and one-off payments, while saving time and reducing costs.

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After all, your $100,000 will not be worth the same after ten years; in fact, it will be worth a lot less. Every year, your money will depreciate by a certain percentage, called the discount rate. The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow.

## Is there a specific function in Excel just for payback periods?

No, basic knowledge of Excel and following step-by-step instructions are enough to calculate the payback period. Investment cost recovery isn’t complete without thinking about profit too. After breaking even, any extra cash made from the project becomes profit for the company or investor. The financial return period goes beyond just getting back what was spent; it leads to making more than what went out.

## Example of Payback Period

Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process. These two calculations, https://simple-accounting.org/ although similar, may not return the same result due to the discounting of cash flows. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest.

The screenshot below shows that the time required to recover the initial $20 million cash outlay is estimated to be ~5.4 years under the discounted payback period method. Based on the project’s risk profile and the returns on comparable investments, the discount rate – i.e., the required rate of return – is assumed to be 10%. The payback period is the time it will take for your business to recoup invested funds. For instance, if your business was considering upgrading assembly line equipment, you would calculate the payback period to determine how long it would take to recoup the funds used to purchase the equipment.

The purchase of machine would be desirable if it promises a payback period of 5 years or less. Using the payback period to assess risk is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR). This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment. Another option is to use the discounted payback period formula instead, which adds time value of money into the equation. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. 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.