What is Payback Period? How to Calculate Payback Period?

What is Payback Period?

The Payback period is the amount of time required to recover the initial business investment. The Payback period is a method of capital budgeting. While comparing two or more investments, the project managers and investors use this method to calculate the amount of time taken to recover the initial investment. Projects with shorter Payback period help investors earn profits easily, whereas projects with a longer payback period are the riskier ones.

Want to know more on Investment Planning? We at IndianMoney.com will make it easy for you. Just give us a missed call on 022 6181 6111 to explore our unique Free Advisory Service. IndianMoney.com is not a seller of any financial products. We only provide FREE financial advice/education to ensure that you are not misguided while buying any kind of financial products.

What is Payback Period? How to Calculate Payback Period?

Salient features of the Payback period:

• The payback period involves a simple calculation i.e. initial investment and the amount of time taken to recover it.
• The payback method does not take into account the time value of money. Other techniques of capital investment consider this concept. Time value of money simply means the value of a rupee today is more than the value of the rupee in the future.
• The Payback method is combined with other techniques of capital budgeting.
• This method cannot be the single determining factor while selecting a project.

Payback Method Advantages:

The payback method has the following advantages:

• The payback period is an easy method of calculation.
• Analysis of the payment period is the measure of risk factor associated with the venture. Therefore, payback period can be used to compare the risk factor associated with various projects.
• It helps companies take informed decisions on investing in certain projects or ventures. It helps them understand how soon they can get the investments back.

Disadvantages of Payback Period:

• Payback period does not take into consideration the time value of money. This is an important factor in determining which projects can give better returns, as some of the businesses generate income in the early years and some businesses generate income in the long run. You can’t get a clear picture on the project, without time value of money.
• One of the main disadvantages of this method is, it does not consider the cash flows received after the payback period.
• It also ignores the profits made by a project, as sometimes the profits/cash flows reduce at the end of the payback period.

Key Takeaways in Payback Periods:

Listed below are some key takeaways from the payback period:

• It refers to the amount of time required to retrieve the initial cost of investment, or the amount of time it takes for investors to hit break-even.
• The fund managers and project managers use this method to determine whether to invest in a project or not.
• Shorter payback periods vis-a-vis business ventures mean, it is a less risky and attractive investment. A longer payback period means the business venture is riskier and less desirable.
• The calculation of payback period includes dividing the amount of investment by the cash flow per year.

How to Calculate Payback Period?

The formula for the calculation of payback period takes into consideration, the cash inflows from the project.

In case the cash inflows are even, then the formula for the calculation of the payback method is:

Payback period = initial investment/ net cash flow per period.

When the cash flow is uneven, the formula used for calculating the payback period is:

Payback period: A + B/C

Where:

A is the last period number where the cumulative cash flow is negative.

B is the absolute value of the cumulative net cash flows at the end of the period A.

C refers to the total cash inflow of the period following period A.

Cumulative cash flow means the sum of inflows to date, minus the initial cash flow.

Payback Period Example:

A transportation company is considering the purchase of a dump truck that costs Rs 28.19 Lakhs and which would generate a net cash flow of Rs 7.2 Lakhs annually. The payback period for this investment is 4 years. The company is also considering the purchase of a long bed truck costing Rs 30.5 Lakhs and would generate an annual income of Rs 8.64 Lakhs. The payback period for this investment is 3.5 years. If the transport company has a budget constraint and is capable of investing in only a single venture at a time, and it’s using only the payback method of calculation for investment decisions, then the second option is considered to be more profitable due to a shorter payback period.

Keep your Financial Cognizance up to date with IndianMoney App. Download NOW for simple tips & solutions for your financial wellbeing.

Have a complaint against any company? IndianMoney.com's complaint portal Iamcheated.com can help you resolve the issue. Just visit IamCheated.com and lodge your complaint. If you want to post a review on any company you can post it on Indianmoney.com review and complaint portal IamCheated.com.

Be Wise, Get Rich.