Payback Period

Define Payback Period

The payback period is the time it takes to earn back the cash invested in a project. It allows a business to determine how long it will take before a project will recover it’s original investment.

The simple payback period, is a useful tool for a business to compare projects. Using the payback period method, the business would choose the project which has the shortest cash payback period.

Payback Period Calculation

The payback period formula is as follows:

Payback Period in years = Cost of project / Annual cash inflows

Payback Period Example

If a business invests in a project whose cost is 150,000 and expects to receive cash inflows of 32,000 per year, then the payback period is

Payback period = Cost of project / Annual cash inflows = 150,000 / 32,000 = 4.69 years.

It will take the business 4.69 years to recover the original investment of 150,000 in the project, as shown in the diagram below.

Pay back Period Example
Project Investment – 150
Year 1 Year 2 Year 3 Year 4 Year 5
+ 32 + 32 + 32 + 32 + 32
Payback Period = 4.69 years

If the business had another project requiring investment of 200,000 with annual cash inflows of 53,000 per year, the payback period of this project would be

Pay back period = Cost of project / Annual cash inflows = 200,000 / 53,000 = 3.77 years.

Using the payback period method, the business would choose the second project as this has the shorter payback period.

Calculating Payback Period for Uneven Cash Flows

To calculate pay back period for uneven cash flows which vary from year to year, calculate the cumulative cash flow at the end of each year until the cumulative cash flow turns positive.

Calculation of Pay back Period
Cash flow Cumulative
Year 0 -160,000 -160,000
Year 1 46,000 -114,000
Year 2 62,000 -52,000
Year 3 20,000 -32,000
Year 4 53,000 21,000

The cumulative cash flow turns positive in year 5, so the pay back period is somewhere between 3 and 4 years, depending on the timing of the final cash inflow of 53,000. At this point the cash inflows exceed the initial investment in the project of 160,000.

Advantages and Disadvantages of Payback Period

Advantages of Payback Period

  • Simple to calculate and easy to understand
  • Adjusts for uncertainty of later cash flows
  • Biased towards liquidity as the quicker the investment in a project is returned the higher rank it will be given

Disadvantages of Payback Period

  • Ignores the time value of money when calculating pay back
  • Requires an arbitrary cutoff point
  • Ignores cash flows beyond the pay back period
  • Does not allow for any risk associated with the cash flows

Payback Period Calculator Download

We have produced a pay back period calculator to enable a business to calculate the pay back period of a project with uneven cash flows on entering the initial project cost and up to ten annual cash inflows.

The Excel pay back period calculator is available for download in Excel format by following the link below.

Payback Period Calculator Spreadsheet Download Link

Payback Period November 6th, 2016Team

You May Also Like

Related pages

journal entries for periodic inventory systeminterest rate implicitcalculate payback period onlinesimple ledger sheetdirect material cost variancerent received in advance journal entrycredits vs debitsaccounting equation chartallocation of factory overheadbank overdraft in balance sheetvouchers templatevacation accrualsamortisation and depreciationcvp income statement formatunearned revenue income statementfixed asset schedule templatejournal entry for bad debtsnpv in accountingpresent value of annuity due of 1 tableprove it test tutorialdebtors journalcommon size analysis income statementgross profit margin chartsample excel spreadsheet for accountingcalculate accounts payable dayspurchase order template xlswhat is overhead apportionmentweighted average periodic inventory methodformat of trial balance in accountingliquidation journal entriesannuity npv200 declining balance formulamarkup vs marginaccounting outstanding checksmeaning of eomaccrued taxes journal entryjournal entry for allowance for doubtful accountssample of general ledger sheetaccounts receivable subsidiary ledger exampleconvert markup to margindouble entry bookkeeping pdftotal labor variance formuladues and subscriptions definitionexcel small business accounting templatewhat is the meaning of prepaid expensesentry for allowance for doubtful accountsstraight line method depreciation exampleexample of adjusting journal entriesrent due to landlord journal entrypv of growing annuitypv on excelproperty dividend journal entrysalary ledger formataging accounts receivablemeaning of accrued incomeaccrued income asset or liabilityaccounting quiz questions and answershow to prepare a retained earnings statement exampleposting journal entries to general ledgercash deposited in bank journal entry in tallyperpetual growth formulatypical journal entries accountingtotal direct materials cost variance formulahalf year rule depreciationfixed declining balance methodgross profit computationannuity npvimprest basishow to calculate retained earnings on balance sheetremittance in accountingreceivables ledger control accountintro to accounting quizt accounts and journal entrieschart of accounts excel templatefifo methodseom invoice