The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. Table of Contents
How to Calculate Payback Period (Step-by-Step)Perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project, the payback period is a fundamental capital budgeting tool in corporate finance. Conceptually, the metric can be viewed as the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached, which is when the amount of revenue produced by the project is equal to the associated costs.
While there certainly are exceptions (i.e., projects that necessitate significant time before generating sustainable profits), a large portion of companies – especially those that are publicly traded – tend to be more short-term oriented and focus on near-term revenue and earnings per share (EPS) targets. For a public company, the share price of the company could falter if near-term sales or profitability goals are not met, as the market is unlikely to uphold the current valuation just because management claims to be operating with a longer-term horizon in mind. Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. 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). How to Interpret Payback Period in Capital Budgeting
Payback Period FormulaIn its simplest form, the calculation process consists of dividing the cost of the initial investment by the annual cash flows. Formula 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. The essential question being answered from the calculation is:
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.
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. But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows. Formula Here, the “Years Before Break-Even” refers to the number of full years until the break-even point is met. In other words, it is the number of years the project remains unprofitable. Next, the “Unrecovered Amount” represents the negative balance in the year preceding the year in which the cumulative net cash flow of the company exceeds zero. And this amount is divided by the “Cash Flow in Recovery Year”, which is the amount of cash produced by the company in the year that the initial investment cost has been recovered and is now turning a profit. Payback Period Calculator – Excel Model TemplateWe’ll now move to a modeling exercise, which you can access by filling out the form below. Step 1. Non-Discounted Payback Period Calculation ExampleFirst, we’ll calculate the metric under the non-discounted approach using the two assumptions below.
Our table lists each of the years in the rows and then has three columns. 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. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. Hence, the cumulative cash flow for Year 1 is equal to ($6mm) since it adds the $4mm in cash flows for the current period to the negative $10mm net cash flow balance. The third and final column is the metric that we are working towards and the formula uses the “IF(AND)” function in Excel that performs the following two logical tests.
If the two are true, that means the break-even occurs in between the two years – and therefore, the current year is selected. But because there is likely a fractional period that we cannot neglect, we must divide the cumulative cash flow balance for the current year (negative sign in front) by the cash flow amount of the next year, which is then added to the current year from earlier. The screenshot below shows the formula in Excel. From the finished output of the first example, we can see the answer comes out to 2.5 years (i.e., 2 years and 6 months). By the end of Year 2, the net cash balance is negative $2mm, and $4mm in cash flows will be generated in Year 3, so we add the two years that passed before the project became profitable, as well as the fractional period of 0.5 years ($2mm ÷ $4mm). Step 2. Discounted Payback Period Calculation AnalysisMoving onto our second example, we’ll use the discounted approach this time around, i.e. accounts for the fact that a dollar today is more valuable than a dollar received in the future. The three model assumptions are as follows.
The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. Here, each cash flow is divided by “(1 + discount rate) ^ time period”. But other than this distinction, the calculation steps are the same as in the first example. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months). The takeaway is that the company retrieves its initial investment in approximately four years and three months, accounting for the time value of money. Step-by-Step Online Course Everything You Need To Master Financial ModelingEnroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks. Enroll Today How do you calculate cash payback period?The payback period is calculated by dividing the amount of the investment by the annual cash flow. Account and fund managers use the payback period to determine whether to go through with an investment.
What is the cash payback method?Simply put, the cash payback technique involves dividing the total cost of the upgrade by the amount of money that the upgrade will make every year. This gives us the cash payback period, or the amount of time we have to wait to see the item pay for itself.
How is cash payback period is computed chegg?Divide the last negative cash flow by the positive cash flow for the immediate next year.
When the cash returns are the payback period is computed by adding the cash returns until the total is equal to the investment?Answer and Explanation: Payback period is calculated by dividing the initial investments by the net annual cash flow when the expected cash flows are equal.
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