# How to calculate the payback period Definition & Formula

The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering.

This can be a problem for investors choosing between two projects on the basis of the payback period alone. One project might be paid back faster, but – in the long run – that doesn’t necessarily make it more profitable than the second. Some investments take time to bring in potentially higher cash inflows, but they will be payback period equation overlooked when using the payback method alone. Alaskan Lumber is considering the purchase of a band saw that costs \$50,000 and which will generate \$10,000 per year of net cash flow. Alaskan is also considering the purchase of a conveyor system for \$36,000, which will reduce sawmill transport costs by \$12,000 per year.

## Payback method with uneven cash flow:

This means that the terminal or the salvage value would not be considered. Hence, the payback period is not a useful method to measure profitability. Say, Kapoor Enterprises is considering investments A and B each requiring an investment of Rs 20 Lakhs today and cash flows at the end of each of the following 5 years. Let’s evaluate how much time does it take to get this initial investment of Rs 20 Lakhs back in each of the projects.

• If you buy solar panels, they might eventually pay for themselves in energy savings.
• Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments.
• Note that an increase in the market price of the product can compensate for the losses incurred in the case of a natural solar dryer.
• For example, you could use monthly, semi annual, or even two-year cash inflow periods.

If we divide \$1 million by \$250,000, we arrive at a payback period of four years for this investment. Others like to use it as an additional point of reference in a capital budgeting decision framework. If you are interested in the financial aspect, then the payback period is an important number for your decision making. A payback period around 10 years, give or take, is pretty average, and could end up being a solid investment, Haenggi said. A “solar payback period” is a fancy way of talking about how long it takes for the money you spent to be outweighed by the money you’re saving (or earning) on your electricity bill.

## Significance and Use of Payback Period Formula

But solar panels are expensive, and you need to consider how long it’ll take for the savings you earn from solar power to outweigh what you paid to put the panels on your roof. Before you invite a crew of solar installers over, you’ll want to understand when — or if — the panels will start to pay for themselves. Since Project B has a shorter Payback Period as compared to Project A, Project B would be better. However, the business entity should not take investment decisions simply on the basis of the Payback Period of the investment proposals given the inherent drawbacks of the Payback Period Method.

The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded.

## Example of Payback Period

(8.1), (8.2) as the former takes the time value of money into consideration [33]. NPV can incidentally be criticized, as large expenditures far in the future are automatically thought fairly unimportant. This can be used to justify projects with very high future decommissioning costs (such as, e.g., oil rigs and nuclear power plants) in ways which green groups disagree with. Payback period tells us how long it takes to get back our capex from revenues/profits.

Payback is often used to talk about government projects or relatively risky projects that are capital intensive. “Industrial and manufacturing companies tend to like payback,” says Knight. Companies that are cash strapped and don’t have a lot of capital to spend may also focus on payback period since they are going to need the money soon. That’s why business owners and managers need to use capital budgeting techniques to determine which projects will deliver the best returns, and yield the most profitable outcome. As an alternative to looking at how quickly an investment is paid back, and given the drawback outline above, it may be better for firms to look at the internal rate of return (IRR) when comparing projects.

## Calculating the Payback Period With Excel

Looking at the example investment project in the diagram above, the key columns to examine are the annual “cash flow” and “cumulative cash flow” columns. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested.