However, to calculate the exact payback period of the project, we need to perform a minor calculation. Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business. Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased. For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month.

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. Return on Investment (ROI) is the annual return you simple payback period receive on investment, and it measures the efficiency of the investment, compared to its cost. A payback period, on the other hand, is the time it takes to recover the cost of an investment. The payback period with the shortest payback time is generally regarded as the best one.

Guide to Understanding Accounts Receivable Days (A/R Days)

For the most thorough, balanced look into a project’s risk vs. reward, investors should combine a variety of these models. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Investors might also choose to add depreciation and taxes into the equation, to account for any lost value of an investment over time. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism.

This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential. Acting as a simple risk analysis, the payback period formula is easy to understand. It gives a quick overview of how quickly you can expect to recover your initial investment.

Discounted Cash Flow

Payback period is popular due to its ease of use despite the recognized limitations described below. There are a variety of ways to calculate a return on investment (ROI) — net present value, internal rate of return, breakeven — but the simplest is payback period. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. In simple terms, the payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash flow is positive, which is the payback year.

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Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. The payback period is a liquidity (cash) focused technique which means that it prefers projects which are expected to recover their initial investment in the minimum time period.

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