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What is the payback period?
To understand what exactly a payback calculator is and how it works, you first need to have some background information on ‘payback period’.
The payback period, simply put, is the time in which the initial investment made into a project is expected to be recovered. This recovering is done through the cash inflow that the investment has stimulated.
In more technical terms, the payback period is the amount of time in which an investment hits the point where it has yielded zero profit and zero loss, that is, it reaches the break-even point.
For example, if you have invested $3000 in a project and make $2000 in the first year following the investment and $1000 the next year, the payback period for your investment will be 2 years. After this amount of time, i.e. 2 years, the money generated will be considered as profit.
What is the benefit of determining the payback period?
Calculating the payback period generally gives an accurate estimate of the cash flows in the immediate future as compared to rather inaccurate results for later times.
This allows businesses to have an insight into the time periods in which initial investments will be returned for different projects. This in turn allows them to decide which investment opportunity they’d rather opt for.
Henceforth, it is not only giving you an overview of how well the related investment will do, but it will also help you decide whether or not you wish to make that particular investment.
What should I consider while using payback period make decisions about investments?
The first and foremost aspect to consider is the length of the payback period.
A shorter payback period means your initial investment will be recovered more quickly. This is done through cash flows generated by that particular investment.
A longer payback period means it will take longer for the initial investment to be recovered.
As you would’ve guessed, a shorter payback period means a more attractive investment. The faster you recover your amount and hit the break-even point, the earlier you will start seeing profits and vice versa. Hence, you should opt for investments with shorter payback periods – provided that is your priority.
Payback calculator – methods involved
To calculate the payback period, you can either use our payback calculator that will perform the calculation for you within seconds, or you can do it manually using one of the following methods:
Subtraction Method: This is used if cash flows are expected to vary year by year. The method involves subtracting yearly cash inflows from the initial cash outflows.
Averaging Method: This is used if cash flows are expected to have little variance in values over the years. It involves diving the yearly cash inflows into the initial expenditure of the project.
Payback formula
The exact formula for manually calculating the payback period is as follows:
Payback period = Initial Investment - Net Cash flow per period
where the net cash flow per period is equal to:
Net cash flow per period = Cash inflow per period-Cash outflow per period
The parameters to be inserted into this formula are:
Initial Investment: The money invested in the project in the beginning
Net cash flow per period: Deduced using the second formula stated, where ‘per period’ means over the amount of time you are calculating
The payback period to be found is given in years.