Payback Period Formula

Payback Period Formula (Table of Contents)

• Payback Period Formula
• Payback Period Calculator
• Payback Period Formula in Excel (With Excel Template)

Payback Period Formula

The payback period can be termed as the tool required for capital budgeting feet can estimate the length of tenure required to reach the capital investment amount from the profitability of the business over the period of time. This period is usually expressed in terms of years and is calculated by dividing the total capital investment required for the business divided by projected annual cash flow.

Here’s the Payback Period Formula –

OR

Where,

• P = Payback period.
• PYFR = Number of Years immediately preceding year of Final Recovery BA = Balance Amount to be recovered
• CIYFR = Cash inflow — Year of the Final Recovery

Example of Payback Period Formula

Let’s take an example to find out the Payback Period for a company: –

A particular Project Cost USD 1 million and the profitability of the project would be USD 2.5 Lakhs per year. Calculate the Payback Period in years.

Using Payback Period Formula, We get-

• Payback period = Initial Investment or Original Cost of the Asset / Cash Inflows
• Payback Period = 1 million /2.5 lakh
• Payback Period = 4 years

Explanation

Payback period is the time required to recover the cost of total investment meant into a business. Payback period is a basic concept which is used for taking decisions whether a particular project will be taken by the organization or not. In simple terms, management looks for a lower payback period. Lower payback period denotes quick break even for the business and hence the profitability of the business can be seen quickly. So in the business environment, lower payback period indicates higher profitability from the particular project. However, the payback period ignores the time value of money. That time value of money deals with the idea of basic depreciation of money due to the passing of time. The present value of a particular amount of money is higher than its future value. In other words, it has been seen that the value of money decreases what time. Thus in case of payback period or calculating breakeven point in case of a business one must include the relevance of opportunity cost as well.

Significance and Usage of Payback Period Formula

One of the major characteristics of the payback period is that it ignores the value of money over the time period. Payback Period formula just calculates the number of years which will take to recover the invested funds from the particular business.

For example, a particular project cost USD1 million and the profitability of the project would be USD 2.5 Lakhs per year. Calculate the payback period in years and interpret it.

So the payback period will be = 1 million / 2.5 lakh or 4 years.

So during calculating the payback period, the basic valuation of 2.5 lakh dollar is ignored over time. That is the profitability of each year is fixed but the valuation of that particular amount will be placed overtime period. Thus the payback period fails to capture the diminishing value of currency over increasing time.

Types of payback period

There are several types of payback period which are used during the calculation of break-even in business. The net present value of NPV method is one of the common processes of calculating payback period which calculates the future earnings at present value. Discounted payback period is a capital budgeting procedure which is frequently used to calculate the profitability of a project. The net present value aspect of a discounted payback period does not exist in a payback period in which the gross inflow of future cash flow is not discounted.

Another method which is frequently used is known as IRR or internal rate of return which emphasizes on the rate of return from a particular project each year. The rate of return may not be the same during all the years. Last but not the least there is a payback rule which is also called payback period and it basically calculates the length of time which is required to recover the cost of investment.

Features of Payback Period Formula

• Payback period is a basic understanding of return and time period required for break even. The payback period formula is very basic and easy to understand for most of the business organization.
• Within several methods of capital budgeting payback period method is the simplest form of calculating the viability of a particular project and hence reduces cost labor and time.
• One of the striking points of the payback period is that it reduces the obsolesce of a particular machine as shorter tenure is preferred in comparison with a larger time frame.
• Companies which have lower cash balances in the balance sheet and has hired date and very weak and liquidity would be beneficial from this kind of method.
• Payback period, however, emphasizes on speedy recovery of investment in capital assets.

Demerits of Payback Period Formula

• A small deviation made in labor cost or cost of maintenance can change the earnings and the payback period.
• This method totally ignores the solvency II the liquidity of the business.
• This method only concentrates on the earnings of the company and ignores capital wastage and several other factors like inflation depreciation etc.
• Time value of money is not at all considered in this method.
• The amount of capital investment is overlooked in payback period so, during capital budgeting decision, several other methods are also required to be implemented.
• This method cannot determine erratic earnings and perhaps this is the main shortcoming of this method as we all know business environment cannot be the same for each and every year.

Suitability of Payback Period Formula

• Payback period is only suitable to the units which don’t have huge amounts in hand
• Payback period is most suitable in dynamic markets and under certain investment scenario.
• As the business world is changing each and every day and the rate of change is accelerating divided most of the business person would prefer a shorter payback period to reduce the risk factor.
• Payback period is commonly referred by the companies which are suffering from a huge debt crisis and want profitability from pilot projects.

Payback Period Calculator

You can use the following Payback Period Calculator

Payback Period Formula in Excel (With Excel Template)

Here we will do the same example of the Payback Period formula in Excel. It is very easy and simple. You need to provide the two inputs i.e Initial Investment and Cash Inflows

You can easily calculate the Payback Period using Formula in the template provided.

You can download this Payback Period Template here – Payback Period Formula Excel Template

Conclusion

Payback period is an essential assessment during calculation of return from a particular project and it is advisable not to use the tool as the only option for decision making. During similar kind of investments, however, a paired comparison is useful.bat in case of detailed analysis like net present value or internal rate of return the payback period can act as a tool with supporting of above those particular formulas.

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