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. The purchase of machine would be desirable if it promises a payback period of 5 years or less. 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. Assume that Company A has a project requiring an initial cash outlay of $3,000.

Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. If undertaken, the initial investment in the project will cost the company approximately $20 million.

- The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend.
- There are many flaws in the technique, but it is better to the payback method than to make long-term investment decisions without using any capital budgeting techniques.
- This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment.

She has worked in multiple cities covering breaking news, politics, education, and more. Most broadly speaking, a good payback period is the shortest payback period possible. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. In this case, the payback period would be 4.0 years because 200,0000 divided by 50,000 is 4.

For example, there may be some marketing channels that produce more profitable customers, faster. Or you may have extremes of customers – from those who join at a heavily discounted price, to those who cost relatively more but that are likely to stay for longer. By aggregating them all together, you can skew the completed contract method definition calculation and get a misleading measurement. Efficient companies are closer to 5 months (or less), while companies lower-performing companies are closer to the 12 month timeframe for payback. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet.

- The CAC Ratio is a more visual representation of the return you’re getting on each new customer.
- At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero.
- In this article, we will explain the difference between the regular payback period and the discounted payback period.
- For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
- The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
- By aggregating them all together, you can skew the calculation and get a misleading measurement.

The discounted payback period determines the payback period using the time value of money. Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money. The value obtained using the discounted payback period calculator will be closer to reality, although undoubtedly more pessimistic. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects.

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). Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes. The opposite stands for investments with longer payback periods – they’re less useful and less likely to be undertaken. A payback period refers to the time it takes to earn back the cost of an investment. More specifically, it’s the length of time it takes a project to reach a break-even point.

For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments. The payback method should not be used as the sole criterion for approval of a capital investment. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one. 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.

This approach works best when cash flows are expected to vary in subsequent years. For example, a large increase in cash flows several years in the future could result in an inaccurate payback period if using the averaging method. It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows.

As a result, payback period is best used in conjunction with other metrics. Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator.

We’ll now move to a modeling exercise, which you can access by filling out the form below. 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. But since the metric rarely comes out to be a precise, whole number, the more practical formula is as follows. 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 discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money. It is the period of time that a project takes to generate cash flows when the cumulative present value of the cash flows equals the initial investment cost. Discounted payback period will usually be greater than regular payback period. Investments with higher cash flows toward the end of their lives will have greater discounting.

Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment.

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. 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. By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more – through a single, user-friendly platform. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. Looking at the best-performing companies in this cohort gives us clues as to how they have created a low payback period.

It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments. For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future.

Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. As you can see in the example below, a DCF model is used to graph the payback period (middle graph below).