Know the Significance of Payback Period

Whether implementing a new software system, adding office space, acquiring another company, or any other substantial investment, companies want to know how long it will take to recoup the money they spend on major purchases. The way to determine this is by calculating the payback period, which is the length of time it takes for the investment to reach a breakeven point. In other words, it tells company executives how long it will be before the investment produces a positive impact on cash.

Why Is Knowing the Payback Period Important?

There are always risks involved in making large corporate expenditures. Companies often need to choose between multiple alternatives when deciding where to spend their hard-earned capital. They also need to know whether a contemplated purchase is a good deal.

Budgeting capital is a vital task in business finance. It is important that the decision-makers in a business strategically compare different projects or potential investments to determine which is most likely to be profitable in the shortest period of time. One way to accomplish this is by calculating the payback period.

In general, a shorter payback period makes for a more attractive investment. Companies want to recover the initial cost of an investment or project as quickly as possible. However, the time horizon and the company’s financial circumstances also need to be taken into account when comparisons are made.

For instance, a company might want to reduce its electric bills. Would it be better to switch to a less expensive power provider or install solar panels? Changing providers might offer a more immediately noticeable benefit, but solar panels could be more cost-effective in the long run. It might even be a good idea to do both. Payback period calculations can help the company decide the best way to proceed.

How Does the Payback Period Relate to the Breakeven Point?

These two terms are sometimes confused. They are related but not synonymous. The breakeven point refers to the amount of money a project or investment must bring in before the initial costs are covered. The payback period indicates how long it will take to reach the breakeven point.

Two Methods of Calculation

There are two ways that companies calculate payback periods. Each has its advantages and disadvantages. There is a simple calculation that is often used for making snap decisions on smaller investments and a more complex calculation that helps evaluate larger, longer-term, or more complex expenditures.

The Simple Method

The easiest way to determine the payback period is with this formula:

Payback Period = Initial Cost ÷ Average Annual Cash Flow

For example, suppose a company wants to invest in a new product line that is projected to bring in $50,000 the first year, $75,000 the second year, and $100,000 in years 3, 4, and 5. The initial cost is anticipated to be $175,000.

In this example the average annual cash flow would be $85,000, and the simple payback period calculation would be:

$175,000 ÷ $85,000 = 2.05 Years

In other words, the initial investment would be recouped in about two years and a month, and the product line would become profitable after that.

This figure can help the company’s financial team decide whether the investment makes sense. Of course, this is only one factor in the decision-making process. The effects on other projects and product lines, personnel deployment, marketing efforts, cash flow, and so forth, would all have to be taken into consideration.

The Discounted Payback Method

The simple method of calculating payback periods has a few drawbacks. For instance, it does not consider the ultimate profitability of the investment, the lifespan of assets, maintenance costs, or the effects of inflation.

To give a better picture of a potential investment, many analysts use the discounted payback period method.

Like the simple calculation, the discounted payback period estimates how long it will take for an investment to reach the breakeven point and start making a profit. But the time value of money also needs to be considered.

The old adage, “a bird in the hand is worth two in the bush” applies here. Money available right now is worth more than the identical amount of money in the future. This is not only due to inflation, but also because of the opportunity costs of spending money rather than saving it or investing it. And there is always the risk that anticipated future income may turn out to be less than expected.

The discounted period measures how long it will take before the cumulative discounted cash flow equals the initial investment. This calculation incorporates a discount rate, which represents the interest rate expected if the money were to be invested for a year. This can be either a published interest rate or a company-defined minimum.

The general formula for calculating the discounted payback period is as follows:

(Image Source: Discounted Payback Period (wallstreetmojo.com). Used with permission.)

Let’s use the previous example and assume a discount rate of 10% for convenience.

The first thing we need to do is calculate the net present value of cash flow. The initial investment is $175,000, so we will call that the cash flow figure for the year before the investment, or Year 0. The simplest formula for determining present value is:

NPV = CF ÷ (1+D)^Y

Where NPV is the net present value, CF is the annual cash flow, D is the discount rate (10% or 0.1), and Y is the year number. There are other more complicated formulas to derive this figure, but in most cases this formula is sufficient.

We can see that the recovery happens in Year 4 when the cumulative discounted cash flow switches from negative to positive. This means the year before the discounted payback period occurs is 3.

Now we can calculate the discounted payback period using the formula:

3 + (-$9,027.73 ÷ $62,092.13) = 3 – 0.15 = 2.85 years

By this method, it will take over two years and ten months to reach the breakeven point and begin to make a profit when the time value of money is considered. Note that the discounted payback period is usually longer than the simple payback period.

In Summary:

• The payback period indicates how long it will take to recoup the initial cost of a project or investment.
• Financial experts such as fractional CFOs use the payback period as one of their tools in determining whether a planned investment is a good idea.
• Shorter payback periods tend to make an investment more desirable.
• There are two main methods of calculating payback periods:
  • The simple calculation is based on actual dollar amounts.
  • The discounted payback period considers the time value of money.
• The payback period should be used in conjunction with several other cash flow and profitability metrics in making an investment decision.
• The payback period should not be the sole factor in determining the value of an investment; there may be many other factors to consider.

If you would like more information or help with your financial tasks, we invite you to contact Preferred CFO today.

About the Author

Al VanLeeuwen

CFO

Al VanLeeuwen is an experienced CFO with significant operations experience. He has helped multiple organizations optimize profitability & helped to lead several successful strategic exits.

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