Payback Period - Explained
What is a Payback Period?
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is a Payback Period?
The payback period is the time it takes to recover the money invested in a project or investment. It does not take into account the time value of money or the expected rate of return. To incorporate these metrics, it is better to employ other methods, such as DCF (Discounted Cash Flow), NPV (Net Present Value) and IRR (Internal Rate of Return).
How Does a Payback Period Work?
Much of corporate finance is related to capital budgeting. Analysts search for a reliable method of determining if a project or an investment will be profitable. One method is to keep in view the payback period. A number of methods for capital budgeting take the Time Value of Money (TVM) into account. It is basically a concept that money is more valuable at the present than in the future. The TVM assigns a specific value to the opportunity cost. The payback period ignores the TVM. To calculate the payback period, divide the amount of money invested by the expected annual return.
Payback Period Example
Suppose, a company invests one million US dollars in a project which, most probably, can save 250,000 USD for the company every year. The payback period will be four years. we divide one million USD by 250,000 USD. Now, suppose, there is another project costing 200,000 USD. There are no cash savings linked to it. But the company earns an return of 100,000 USD every year for the coming twenty years, i.e. two million US dollars. We divide 200,000 USD by 100,000 USD to arrive at a two year PayBack period.