Introduction
Every capital project, such as expanding a business, developing new products, and implementing new technologies, comes with a cost. A business must assess the viability of the investment to ensure it will generate sufficient returns through methods such as breakeven analysis and metrics like net present value and internal rate of return. One convenient way to gauge how long it will take to recover the initial investment is the payback period. This is not only used by businesses but also by individuals making investments. Here, we’ll understand the payback period definition, formula, and when and why you should use it in your investment process.
What Is the Payback Period?
The payback period is simply the time it takes for you to recover the initial cost of your investment. It’s not a very comprehensive metric and has its limitations, which is why financial analysts use it in addition to more detailed metrics like NPV and IRR to get a fuller picture of an investment’s performance. The payback period is useful for assessing how soon you can start seeing returns but doesn’t account for the time value of money. Here’s an example to help you understand the payback period meaning better.
Example
Imagine your society is trying to cut down on rising water bills. After some discussion, all residents decide to install a rainwater harvesting system. They get a quote of Rs. 2 lakh for the full setup, in a one-time investment. The residents estimate that the society can save around Rs. 25,000 each year on water bills and tankers. We can calculate how long it will take to recover the Rs. 2 lakh investment using the payback period. So, what is payback period formula?
Payback Period = Initial Cost of Investment / Annual Cash Flow (In this case, annual savings)
Payback Period = Rs. 2,00,000 / Rs. 25,000 = 8 years.
Your society will fully recover its investment in 8 years after which all future savings directly benefit the residents. You can use this figure to estimate whether or not the investment is worth it. So to define payback period, we can say it is the time it takes for the cash inflows from an investment to equal the original investment cost.
How the Payback Period Works
The payback period method measures the time it takes for cash flows to make up for the cost of an investment. The idea is simple, the shorter the period, the quicker you will recover your initial costs and start to profit. But to effectively calculate this timeframe, you’ll need to accurately know two things:
- The initial cost of the investment, and
- The cash inflows you can expect from the investment.
Both these factors can vary significantly depending on the type of investment, so the ideal payback period also differs from one scenario to another. So, what is payback period method used for? It is used by companies and investors alike to assess when they can expect to break even. For example:
A manufacturing company is looking to build a new factory. They’ll assess the cost of the project (like land, construction, labour, machinery, operational expenses etc.), as well as the income the new factory can generate from the products it will produce. The payback period can help the company determine how many years it will take for the income from the factory to offset the investment.
Similarly, you can use it on a smaller scale. If you buy a solar geyser, you can use the payback period to determine how long it will take for the savings on your electricity bill to cover the cost of the installation.
How to Calculate Payback Period
The payback method depends on cash flows. When the inflows are even, the payback period calculation is quite simple. You divide the initial cost of investment by the annual cash flow as we saw in the example above. But it’s rare for the inflows to be evenly spread. Here’s how to calculate payback period when the annual cash flow is uneven.
Let’s suppose:
The initial cost of an investment is Rs. 10 lakh. The expected cash flows from this investment are:
- First Year: Rs. 1,80,000
- Second Year: Rs. 2,70,000
- Third Year: Rs. 3,00,000
- Fourth Year: Rs. 4,00,000
We’ll take the unrecovered investment approach. We start with an initial investment of Rs. 10,00,000. Each year, we subtract the cash inflows from the remaining investment to see how much is yet to be recovered.
After Year 1
Cash inflow: Rs. 1,80,000
Unrecovered amount: Rs. 10,00,000 – Rs. 1,80,000 = Rs.8,20,000
After Year 2
Cash inflow this year: Rs. 2,70,000
Total cash inflows so far: Rs.1,80,000 + Rs. 2,70,000 = Rs. 4,50,000
Unrecovered amount: Rs. 10,00,000 – Rs. 4,50,000 = Rs. 5,50,000
After Year 3
Cash inflow this year: Rs. 3,00,000
Total cash inflows so far: Rs. 4,50,000 + Rs. 3,00,000 = Rs. 7,50,000
Unrecovered amount: Rs. 10,00,000 – Rs. 7,50,000 = Rs. 2,50,000
After Year 4
Cash inflow this year: Rs. 4,00,000
Total cash inflows so far: Rs. 7,50,000 + Rs. 4,00,000 = Rs. 11,50,000
We can see that the total cash inflows after 4 years exceed the cost of investment, so the period lies somewhere between Year 3 and Year 4. To get to the exact time it took to recover the investment during these years, we’ll divide the unrecovered investment amount by the cash flow of Year 4. So,
Unrecovered amount by Year 3 = Rs. 2,50,000
Cash inflow in Year 4 = Rs. 4,00,000
Time = Rs. 2,50,000 / Rs. 4,00,000 = 0.625
Total time to recover initial costs = 3 years + 0.625 years = 3.625 years.
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Payback Period Formula
The payback period formula for even cash flows is pretty straightforward:
Payback Period = Initial Cost of Investment / Annual Cash Inflow
So if your investment costs Rs. 1,00,000 and you expect to get an average of Rs. 25,000 net inflow every year, you’ll recoup the costs by 4 years.
The pbp formula for uneven cash flows is similar. As the example in the previous section showed us, we can use the cumulative method or the unrecovered costs method to come to the same conclusion. The difference is right at the end. For the year where money is recovered over the investment cost, you divide the unrecovered amount by the cash flow of that year.
An investment planner may use these methods to show you quickly how long it will take your investment to come to fruition, but this is not the only metric they’ll use for a more detailed analysis.
Benefits of Using the Payback Period
- Among the main advantages of payback period is simplicity. Anyone can easily calculate it and get an estimate of the time it will take them to recoup their initial costs.
- The payback period method is one of many metrics that helps investors understand whether their project is desirable.
- The shorter the period, the more attractive the investment as you’ll start profiting faster.
- It can also help investors assess risk. Shorter payback means less risk as you’re not locked into long-term uncertainty.
- Ultimately, it’s one component among others (IRR, NPV, DCF) that can guide more educated decisions about prioritising projects and allocating resources efficiently.
When Would You Use the Payback Period?
In financial investment planning, the pay back period is most commonly used when one needs to get a quick estimate of how long it will take to recover an investment. It’s also helpful when evaluating capital projects where time is a key factor or when liquidity matters more than long-term profitability. For example, a company with limited liquidity would prefer a project that recovers its cost in two years over another that takes five years even if it offers higher profits in the long run. That’s because such a company would consider liquidity more important than profitability to maintain operations.
Similarly, a financial consultant can help small businesses understand whether buying new machinery, vehicles, or technology would be beneficial for them. Individuals can use the payback period too. You can evaluate personal investments like installing solar panels, taking certification courses, or starting a small business, and understand whether these investments are worth making.
What is a Good Payback Period?
A good payback period depends on factors like the type of investment, the company’s liquidity concerns, and its risk appetite. In general, the shorter it is, the better as you’d ideally want to make back your money as quickly as possible. The longer it stays in limbo, the more you’re exposed to risks. If you’re investing in real estate, the payback period is going to be naturally higher than if you’re buying a car for your taxi business. So what counts as a good period depends on many things, which is why one should only compare the payback periods of similar types of investments.
Downsides of Using the Payback Period
While quick and easy to use, the payback period method has its fair share of limitations:
Time Value of Money
The biggest downside is perhaps that the payback period ignores the time value of money. The money you have in hand today will not be the same value a year later due to factors like inflation. For long-term investments, this can significantly distort the actual profitability of a capital project. That’s why an expert like a mutual fund advisor might use the discounted payback period method as it uses present values of future cash inflows. It gives a much more realistic picture of the time it will take to recoup costs.
Ignores Cash Flows After The Payback Period
This method is only concerned with the time taken to recover costs, meaning once you make your money back, the formula does not account for any additional cash inflows, which are important in calculating the profitability of a project. For example, if two projects have the same payback period, but one generates far more income in the long run, the formula would treat them equally.
You should never solely rely on this method. You’ll find that a professional such as a mutual fund investment planner or tax planner uses it as a supporting metric alongside others like net present value, discounted cash flow, and internal rate of return for better results.
Conclusion
The payback period is an easy-to-use metric that tells you about the time it will take to recoup an investment. Different investments have different ‘good’ payback periods, though in general the quicker you get your money back the better. This metric is always used alongside other tools like NPV, DCF, and IRR as its usefulness on its own is limited. It ignores the time value of money as well as cash flows after the payback period, which affects profitability.
