Payback Period Formula
Payback Period =
Initial Investment / Periodic Cash Flow
What is Payback Period?
The payback period formula is used to determine the length of time it will take to recover the initial amount invested on an investment. Payback period is used to evaluate whether or not to puruse a project or investment. Typically, the longer the payback period is, the less desireable the investment is because the capital could be used elsewhere. It is important to note that the payback period does not take into consideration the time value of money. When the time value of money is needed for evaluation purposes, typically NPV, Internal Rate of Return (IRR), or discounted cash flow is used.
Payback Period Example
Shoeburger Corp is considering a project to invest $400,000 on a new corporate headquarters. The new facility will allow the company to consolidate and is expected to save the company $100,000 a year. The payback period for the investment is four years; $400,000 divided by $100,000. Shoeburger Corp is considering an alternative project that will cost the company $100,000, and there is no anticipated savings, but the project is expected to provide the company with an expected annual stream of $50,000 a year for the next 10 years; $500,000.
How long will it take to pay the second investment alternative back? To find the answer, divide the investment by the annual cash stream; $100,000 / $50,000 = 2 years. It will take 2 years for the payback period.
In looking at the two alternatives, Shoeburger Corp. should invest in alternative number two because it will take half the time to receive payback and the potential earnings is greater than alternative one. Keep in mind this is only looking at payback period and not taking into consideration time value of money; there may be additional criteria you would want to evaluate to ensure this investment is truly the best.
The following is a very good explanation of Payback Period and how to calculate it.