The Payback Period Calculator calculates the total time period in which a project repays its initial investment. It is an investment appraisal technique that determines the number of years it takes a project to cover its initial capital outlay or cash outflow. It is not wrong to say that the payback period is the break-even point of a project. In this period, the outflow of funds from a project is equal to the inflow of funds.
You can easily understand this concept using an example. Suppose you have invested $2,500 in Project X and earn $750 at the end of each year. Therefore, Project X will take 3.33 years, i.e., $2500 / $750. At this level, the total inflows from the project are equal to the total outflow for the project.
Formula for Calculating Payback Period
The payback period can be calculated by dividing the initial investment from the total annual cash flow.
Payback Period = Initial investment / Total annual cash flow from the project.
About the Calculator / Features
Payback Period Calculator is an online tool that calculates the result effortlessly by simply entering the following values.
- Initial investment
- Total annual cash flow from the project
How to Calculate using Payback Period Calculator
To use the payback period calculator, the user must provide the following data to the calculator:
It is the amount that the investor invests in the project in order to profit from this project. The important point to note is that it is not the first cash outflow but the total outflow/spend to bring the project to the operational stage. And that may be in one year or more.
Total Annual Cash Flows
It is the sum of the cash flow that the investor earns at the end of each year, which is the denominator of the formula.
Example of Payback Period
Let’s try to understand the concept of the payback period using an example. Suppose XYZ ltd had invested $200,000 in Project Z. The project earns a return of $40,000 at the end of each year. You have to determine the payback period of the project.
PBP = 5 years, i.e. $200,000 / $40,000
Interpretation of Payback Period
The standard rule says the shorter the payback period, the better it is. A shorter payback period determines that the project is efficient in giving back the initial investment at a fast pace, and all subsequent cash flows will lead to earnings or profits from the implementation of that project. In the example above, the payback period is 5 years, which we can shorten to a shorter period if the project has achieved higher returns. Again, this period could be increased if the returns were lower than what it earned.
The main disadvantage of using the payback period is that it does not consider the project returns generated after the payback period. If, for example, the life of the project in the example above was 10 years, this method does not consider the remaining cash flows generated in the remaining 5 years of the project. Neither does this method of capital budgeting take into account the concept of the fair value of the money that can result in losses for the project, nor does it take into account the opportunity costs of the project. It is better to use the discounted payback period method instead of simply using the payback period method, as it would take into account the concept of the time value of money.
Still, analysts use this as quick qualifying criteria, particularly for a short life project. As it does not involve lots of estimation, data points, and complex calculations to arrive at the discounted cash flow/net present value, etc.