Payback Period

The payback period is the number of years required to recover the original investment in a project. The payback is based on cash flows. For example, if you invest $10 million in a project, how long will it be until you recover the full original investment? Below table illustrates the calculation of the payback period by following an investment’s cash flows and cumulative cash flows.

 

Year

0

1

2

3

4

5

Cash Flow

-10000

2500

2500

3000

3000

3000

Cumulative Cash Flow

-10000

-7500

-5000

-2000

1000

4000

 

In the first year, the company recovers 2,500 of the original investment, with 7,500 still unrecovered. You can see that the company recoups its original investment between Year 3 and Year 4. After three years, 2,000 is still unrecovered. Since the Year 4 cash flow is 3,000, it would take two-thirds of the Year 4 cash flow to bring the cumulative cash flow to zero. So, the payback period is three years plus two-thirds of the Year 4 cash flow, or 3.67 years. The drawbacks of the payback period are transparent. Since the cash flows are not discounted at the project’s required rate of return, the payback period ignores the time value of money and the risk of the project. Additionally, the payback period ignores cash flows after the payback period is reached. In the table above, for example, the Year 5 cash flow is completely ignored in the payback computation.

 

Payback Period

Microsoft Excel 2010
Family Budget Planner Spreadsheet
Payback Period
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