Payback Period Definition
Payback period can be defined as period of time required to recover its initial cost and expenses and cost of investment done for project to reach at time where there is no loss no profit i.e. breakeven point.
source: Lifehacker.com.au
The above article notes that Tesla’s Powerwall is not economically viable for most people. As per the assumptions used in this article, Powerwall’s payback ranged from 17 years to 26 years. Considering Tesla’s warranty is only limited to 10 years, the payback period higher than 10 years is not ideal.
Payback Period Formula
The payback period formula is one of the most popular formulas used by investors to know how long it would generally take to recoup their investments and is calculated as the ratio of the total initial investment made to the net cash inflows.
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For eg:
Source: Payback Period (wallstreetmojo.com)
Steps to Calculate Payback Period
- The first step in calculating the payback period is determining the initial capital investment and
- The next step is calculating/estimating the annual expected after-tax net cash flows over the useful life of the investment.
Calculation with Uniform cash flows
When cash flows are uniform over the useful life of the asset, then the calculation is made through the following formula.
Payback period Formula = Total initial capital investment /Expected annual after-tax cash inflow.
Let us see an example of how to calculate the payback period when cash flows are uniform over using the full life of the asset.
Example:
A project costs $2Mn and yields a profit of $30,000 after depreciation of 10% (straight line) but before tax of 30%. Lets us calculate the payback period of the project.
Profit before tax $ 30,000
Less: Tax@30%(30000*30%) $ 9,000
Profit after tax $ 21,000
Add: Depreciation(2Mn*10%) $ 2,00,000
Total cash inflow $ 2,21000
While calculating cash inflow, generally, depreciation is added back as it does not result in cash out flow.
Payback Period Formula = Total initial capital investment /Expected annual after-tax cash inflow
= $ 20,00,000/$2,21000 = 9 Years(Approx)
Calculation with Nonuniform cash flows
When cash flows are NOT uniform over the use full life of the asset, then the cumulative cash flow from operationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more must be calculated for each year. In this case, the payback period shall be the corresponding period when cumulative cash flows are equal to the initial cash outlay.
In case the sum does not match, then the period in which it lies should be identified. After that, we need to calculate the fraction of the year that is needed to complete the payback.
Example:
Suppose ABC ltd is analyzing a project which requires an investment of $2,00,000 and it is expected to generate cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more as follows
| Year Annual cash inflows | |
|---|---|
| 1 | 80,000 |
| 2 | 60,000 |
| 3 | 60,000 |
| 4 | 20,000 |
In this cash payback period can be calculated as follows by calculating cumulative cashflows
| Year | Annual cash inflows | Cumulative Annual cash inflows | Payback period |
|---|---|---|---|
| 1 | 80,000 | 80,000 | |
| 2 | 60,000 | 1,40,000(80,000+60,000) | |
| 3 | 60,000 | 2,00,000(1,40,000+60,000) | In this Year 3 we got initial investment of $ 2,00,000 so this is the pay back year |
| 4 | 20,000 | 2,20,000(2,00,000+20,000) |
Suppose, in the above case, if the cash outlay is $2,05,000, then pa back period is
| Year | Annual cash inflows | Cumulative Annual cash inflows | Payback period |
|---|---|---|---|
| 1 | 80,000 | 80,000 | |
| 2 | 60,000 | 1,40,000(80,000+60,000) | |
| 3 | 60,000 | 2,00,000(1,40,000+60,000) | |
| 4 | 20,000 | 2,20,000(2,00,000+20,000) | The payback period is between 3 and 4 years |
For up to three years, a sum of $2,00,000 is recovered, the balance amount of $ 5,000($2,05,000-$2,00,000) is recovered in a fraction of the year, which is as follows.
Forgetting $20,000 additional cash flows, the project is taking complete 12 months. So for getting additional of $ 5,000($2,05,000-$2,00,000) it will take (5,000/20,000) 1/4th Year. i.e., 3 months.
So, the project payback period is 3 years 3 months.
Advantages
- It is easy to calculate.
- It is easy to understand as it gives a quick estimate of the time needed for the company to get back the money it has invested in the project.
- The length of the project payback period helps in estimating the project risk. The longer the period, the riskier the project is. This is because the long-term predictions are less reliable.
- In the case of industries where there is a high obsolescence risk like the software industry or mobile phone industry, short payback periods often become determining a factor for investments.
Disadvantages
The following are the disadvantages of the payback periodDisadvantages Of The Payback PeriodPayback period is a very simple method for calculating the required period; it does not involve much complexity and aids in analyzing the project's reliability. Its disadvantages include the fact that it completely ignores the time value of money, fails to depict a detailed picture, and ignores other factors as well.read more.
- It ignores the time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more
- It fails to consider the investment total profitability (i.e. it considers cash flows from the initiation of the project until the payback period and fails to consider the cash flows after that period.
- It may cause the company to place importance on projects which are short payback period, thereby ignoring the need to invest in long-term projects( i.e, A company cannot just determine project feasibility only based on the number of years in which it is going to give your return back, there are number of other factors which it does not consider)
- It does not take into account the social or environmental benefits in the calculation.
Payback Reciprocal
Payback reciprocal is the reverse of the payback period, and it is calculated by using the following formula
Payback reciprocal = Annual average cash flow/Initial investment
For example, a project cost is $ 20,000, and annual cash flowsAnnual Cash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are uniform at $4,000 per annum, and the life of the asset acquire is 5 years, then the payback period reciprocal will be as follows.
$ 4,000/20,000 = 20%
This 20% represents the rate of return the project or investment gives every year.
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