May 10, 2022/ Steven Bragg
The payback period is the time required to earn back the amount invested in an asset from its net cash flows. It is a simple way to evaluate the risk associated with a proposed project. An investment with a shorter payback period is considered to be better, since the
investor's initial outlay is at risk for a shorter period of time. The calculation used to derive the payback period is called the payback method. The payback period is expressed in years and fractions of years. For example, if a company invests $300,000 in a new production line, and the production line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback). The formula for the payback method is
simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash inflow generated by the project per year (which is assumed to be the same in every year). 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. The payback period for this capital investment is 5.0 years. 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 payback period for this capital investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using the payback method as the basis for its investment decision, it would buy the conveyor system, since it has a shorter payback period. The payback period is useful from a risk analysis perspective, since it gives a quick picture of the amount of time that the initial investment will be at risk. If you were to analyze a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods and reject those having longer ones. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. Though the payback method is widely used due to its simplicity, it suffers from the following problems:
Payback Method Example #2ABC International has received a proposal from a manager, asking to spend $1,500,000 on equipment that will result in cash inflows in accordance with the following table:
The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. Instead, the company's financial analyst runs the calculation year by year, deducting the cash flows in each successive year from the remaining investment. The results of this calculation are:
The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years. Evaluation of the Payback MethodThe payback method should not be used as the sole criterion for approval of a capital investment. Instead, consider using the net present value or internal rate of return methods to incorporate the time value of money and more complex cash flows, and use throughput analysis to see if the investment will actually boost overall corporate profitability. There are also other considerations in a capital investment decision, such as whether the same asset model should be purchased in volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would make more sense than an expensive "monument" asset. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. Terms Similar to the Payback MethodThe payback period formula is also known as the payback method. How do you calculate payback period using uneven cash flow in Excel?First, input the initial investment into a cell (e.g., A3). Then, enter the annual cash flow into another (e.g., A4). To calculate the payback period, enter the following formula in an empty cell: "=A3/A4" as the payback period is calculated by dividing the initial investment by the annual cash inflow.
What formula do you use to calculate the payback period?The payback period is calculated by dividing the amount of the investment by the annual cash flow.
When calculating a project's payback period cash flows are?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.
How do you calculate cumulative cash flow on a payback period?Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.
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