Payback period
For a working spreadsheet example of payback period calculations, download the free financial metrics tool (click here).
Like internal rate of return, 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), usually measured in years. Other things being equal, the better investment is the one with the shorter payback period.
Also, payback periods are sometimes used as a way of comparing alternative investments with respect to risk: other things being equal, the investment with the shorter payback period is considered less risky.
As an example, consider a $150 software purchase that is expected to improve productivity valued at $60 per year for the next three years:
| |
Paid Out |
Paid Back |
Total Paid Back |
Year 1 |
$100 |
$60 |
$60 |
Year 2 |
|
$60 |
$120 |
Year3 |
|
$60 |
$160 |
Payback obviously occurs in Year 3, but where, precisely? The "formula" for payback period is a little cluttered, but it should be simple to follow. (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 at the end of final payback year - Total Paid back at the start of the final payback year
For the example,
Payback Period = 2 + ($150 - $120) / ($180 - $120)
Payback Period = 2 + 30/60 = 2.5 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.
- 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 shortest 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).
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