If the company requires a payback period of two years or less, the first investment is preferable. However, the first investment generates only $3,000 in cash after its payback period while the second investment generates $35,000 after its payback period. The payback method ignores both of these amounts even though the second investment generates significant cash inflows after year 3. Again, it would be preferable to calculate the IRR to compare these two investments.

However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. Given its nature, the payback period is often used as an initial analysis that can be understood without much technical knowledge. It is easy to calculate and is often referred to as the “back of the envelope” calculation. Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment.

  1. The payback method should not be used as the sole criterion for approval of a capital investment.
  2. In short, a variety of considerations should be discussed when purchasing an asset, and especially when the investment is a substantial one.
  3. The method is extremely simple to understand, as it only requires one straightforward calculation.
  4. In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5.

According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years. According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. The discounted payback period determines the payback period using the time value of money. The following table shows the expected cash flows from investment proposals A and B.

Since Project B has a shorter Payback Period as compared to Project A, Project B would be better. However, the business entity should not take investment decisions simply on the basis of the Payback Period of the investment proposals given the inherent drawbacks of the Payback Period Method. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.

When Would a Company Use the Payback Period for Capital Budgeting?

This review problem is a continuation of Note 8.22 “Review Problem 8.3” and Note 8.26 “Review Problem 8.4” and uses the same information. The management of Chip Manufacturing, Inc., would like to purchase a specialized production machine for $700,000. The machine is expected https://simple-accounting.org/ to have a life of 4 years and a salvage value of $100,000. 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.

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The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows. The discounted payback period is the number of years it takes to pay back the initial investment after discounting cash flows. In Excel, create a cell for the discounted rate and columns for the year, cash flows, the present value of the cash flows, and the cumulative cash flow balance. Input the known values (year, cash flows, and discount rate) in their respective cells. Use Excel’s present value formula to calculate the present value of cash flows.

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. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. 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.

When the payback period method is used, a company will set a length of time in which a project must recover the initial investment for the project to be accepted. Projects with longer payback periods than the length of time the company has chosen will be rejected. If Sam’s were to set a payback period of four years, Project A would be accepted, but Projects B, C, and D have payback periods of five years and so would be rejected.

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But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period; however, they could have varying flows of cash.

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 sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). Capital Budgeting is one of the important responsibilities of a finance manager of a company. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below.

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. According to what type of corporation is a nonprofit, machine Y is more desirable than machine X because it has a shorter payback period than machine X. As mentioned above, Payback Period is nothing but the number of years it takes to recover the initial cash outlay invested in a particular project. Various capital budgeting techniques are used to help management evaluate various investment projects. Payback Period is one of the techniques used to analyze whether a particular investment project should be accepted or rejected.

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. Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater. As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line.

How to calculate payback period

Sam’s choice of a payback period of four years would be arbitrary; it is not grounded in any financial reasoning or theory. No argument exists for a company to use a payback period of three, four, five, or any other number of years as its criterion for accepting projects. However, we know that money has a time value, and receiving $6,000 in year 1 (as occurs in Project C) is preferable to receiving $6,000 in year 5 (as in Projects B and D). From what we learned about the time value of money, Projects B and C are not identical projects. The payback period method breaks the important finance rule of not adding or comparing cash flows that occur in different time periods. Using the payback period to assess risk is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR).

However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested.

The payback period method does not differentiate between these two projects. 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. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1.