Payback Period Calculation

What is the payback period of an investment? How is it calculated? Read, to know all about it.
Every investment that you make in your life, comes at a certain cost, that you pay out of your income. Good financial management is all about making good income-generating investments that secure your future. Calculation of payback period is important, when it comes to planning out your investments.

Definition

Time is a variable which needs to be considered in any investment equation. The payback period of an investment is related to this time element. When making an investment as a part of financial management for business purposes, one must know how to calculate the returns on it, as there are many calculations that need to be made. That is because, bearing the cost of an investment till it starts paying off, is a risk that must be taken.

Making a business investment like buying new machinery or buying a new place for business, is about taking a calculated risk. The payback period is simply the amount of time required for the cost of investment to be repaid through incoming cash flow. If an investment is something that is going to bring in more business, then its payback period is the time required to recover its cost, from cash inflows. Only after that period of an investment is over, does it start making actual profits.

To be able to calculate this period, one needs to have an idea about the expected rate of return or projected future cash inflow, that is generated by the investment. The nature of the investment and the way it is going to affect your business profits, will help you make a cash inflow forecast. If you can get this forecast, calculating the period is very easy.

Discounted payback period, takes into account, the debt interest and inflation effects on the initial investment, while calculating the time required to break even in a project.

Formula

Calculating the period is very simple and all it needs are two parameters. First parameter required is the total cost of investment and the second one is the projected cash inflow per year. When calculating the period for uneven cash flow, take the average yearly cash flow into consideration. Here is the formula that you need.

Payback Period (In Years) = Total Investment Cost/Yearly Cash Inflow

A fixed yearly cash flow makes the calculation easier and more accurate.

Example

Consider that you made an investment in the retail business, which cost you about USD 100,000. According to your business forecast, your investment will yield USD 20,000 of return on investment (ROI) per year. What will be the payback period?

All that you need to do is substitute the values of total investment and yearly cash inflow, in the above formula. The calculation will proceed in the following way:

Payback Period = USD 100,000/USD 20,000 = 5 Years

So, your initial investment will be recovered in 5 years and that is the period of time, which you will require to break even. It is essential that you make this calculation, before going ahead with an investment, as it will let you know when your investment will actually start earning you money, after recovering initial cost.
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