Formula to Calculate Payback Period
Payback period formula is one of the most popular formulas used by investors to know how long it would generally take to recoup their initial investments.
High Rise Ltd. has been looking at different investments. They have short-listed three investments that seem to be attractive enough in terms of return. Among these three, they want to choose just one. The only criterion of this selection is the payback formula.
Here is a snapshot of three investments –
- Initial investment – $100,000; Cash inflow per year – $20,000.
- Initial investment – $150,000; Cash inflow per year – $50,000.
- Initial investment – $120,000; Cash inflow per year – $60,000.
From the point of view of payback, which project High Rise Ltd. should choose?
First, let’s calculate the payback period of the above investments.
The Payback Formula = Initial investment made / Net annual cash inflow
- For Investment A, the payback is = $100,000 / $20,000 = 5 years.
- For Investment B, the payback is = $150,000 / $50,000 = 3 years.
- For Investment C, the payback is = $120,000 / $60,000 = 2 years.
On the basis of payback, High Rise Ltd. should choose Investment C since the payback of this particular investment is significantly lower.
Let’s take an example to illustrate the payback. Let’s say that you have enrolled for an MBA. The fees for the MBA program are $100,000. The institute has promised that if you can complete your MBA program successfully, you would get a job that would pay around $50,000 per annum in the beginning.
So, if you make a rough calculation of how much time it would take to get back the money you have invested in your MBA program, then you need to calculate the payback. And here’s what you should do.
You just need to divide your initial investment by the salary you would expect to get. Actually, you should do this calculation before you ever decide to invest in an MBA program.
And here’s the calculation for the payback (the above example) = $100,000 / $50,000 = 2 years.
Use and Relevance of Payback Period Formula
There are few reasons why this method is so very popular –
- First of all, it is very easy to calculate. All you need to remember is the initial investment and the cash inflow in the near future.
- Secondly, the Payback Period formula gives a tentative period of time to recoup your initial investment and as a result, you can make a prudent decision.
However, payback has a few limitations as well.
- Firstly, the calculation of payback is overly simplistic. As a result, you may find it easy to calculate; but the result is not very accurate.
- Secondly, payback doesn’t take the time value of money into the account. The value of $100 today won’t be the same in the next year.
- Thirdly, payback doesn’t track the ultimate profitability of the project. It concentrates too much on recouping the initial investments.
You can use the following Payback Period Calculator
|Payback Period Formula =||
Payback Period in Excel (with excel template)
Let us now do the same example as above in Excel. This is very simple. You need to provide the two inputs of Initial investment made and Net annual cash inflow.
You can easily calculate the Payback in the template provided.
This has been a guide to the Payback period formula, its usefulness along with examples. Here we also provide you with a payback period calculator along with Payback Period Formula excel template download. You may also have a look at these articles below to learn more about Corporate Finance.
- Payback Period Advantages and Disadvantages
- Real-Life Examples of Break-Even Analysis
- How to Create a Break-Even Chart?
- Advantages of Break-Even Analysis
- Importance of Break-Even Point in Accounting
- Financial Modeling Templates
- XNPV vs NPV
- IRR vs NPV
- Break-Even Point Formula
- Payback vs Discounted Payback