Payback period
Payback Period is a financial metric that attempts to answer the question: How long does it take for the investmnt to pay for itself? (How long does it take for incoming retuns to cover costs?)
Like some other financial metrics, internal rate of return (IRR) and Return on investment (ROI), the payback period metric takes essentially an "Investment" view of the action, plan, or scenario, and its estimated cash flow stream. Payback period is the length of time required to recover the cost of an investment (e.g. purchase of computer software or hardware, training expenses, or new product development), usually measured in years. Other things being equal, the better investment is the one with the shorter payback period.
Payback period is sometimes used to compare alternative investments with respect to risk: other things being equal, the investment with the shorter payback period is considered less risky.
Payback period is usually calculated from the following cash flow figures for an investement (or business case scenario):
- The net cash flow for each period (the net of cash outflows and inflows for each period).
- The cumulative cash flow at the end of each period.
For working spreadsheet examples of payback period calculations using such figures see either the free financial metrics tool (click here) or the more in-depth Financial Metrics Pro.
As an example, consider a $240 software purchase that is expected to improve productivity valued at $100 per year for the next three years:
Cash | Cash | Cumulative Cash Flow | |
Year 1 | - $240 | $100 | - $140 |
Year 2 | $0 | $100 | - $40 |
Year3 | $0 | $100 | $60 |
Payback obviously occurs in Year 3, but where, precisely? The "formula" for payback period is simple (but surprisingly cumbersome to implement in a spreadsheet). In the example, note that Year 3 is the final Payback Year).
Payback Period = A + ( B / C ) where
A = Years before final payback year
B = Total to be paid back - Total paid back at start of final payback year
C = Total paid back in the entire payback year
For the example,
Payback Period = 2 + (240 - 200) / (100)
Payback Period = 2 + 40/100 = 2.4 Years
Payback period is an appealing metric because its interpretation is easily understood. Nevertheless, here are some points to keep in mind when using it:
- Payback cannot be calculated if the positive cash inflows do not eventually outweigh the cash outflows. That is why payback (like IRR) is of little use when used with a pure "costs only" business case or cost of ownership analysis.
- There can be more than one payback period for a given cash flow stream. Payback period examples such as the one above typically show cumulative cash flow increasing continuously. In real world cash flow results, however, cumulative cash flow can decrease as well as increase from period to period. When cumulative cash flow is positive in one period, but negative again in the next, there is more than one Payback Period point.
- Payback period by itself says nothing about cash flows coming after the payback time. One investment may have a shorter payback period than another, but the latter may go on to greater cumulative cash flow over time.
- Payback calculation ordinarily does not recognize the time value of money (in a discounting sense) nor does it reflect money coming in after payback (contrast with discounted cash flow and internal rate of return, above)
- Other things being equal, the action or investment with the shorter payback period is the better investment because it is less risky. It is usually assumed that the longer the payback period, the more uncertain are the positive returns. For this reason, payback period is often used as a measure of risk, or a risk-related criterion that must be met before funds are spent. A company might decide, for instance, to undertake no major investments or expenditures that have a payback period over, say, 3 years.
For a working spreadsheet example of payback period calculations, download the free financial metrics tool (click here). For more in-depth coverage of payback period rationale, strengths, weaknesses, alternative calculations, and spreadsheet implementation, see Financial Metrics Pro.
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