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Print this chapterThe Payback Method
Read this section on the Payback Method of investing and review the examples of how this method is used.
Calculating the Payback Period
LEARNING OBJECTIVE
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Calculate an investment's payback period
KEY POINTS
- Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year, then accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.
- Some businesses modified this method by adding the time value of money to get the discounted payback period. They discount the cash inflows of the project by the cost of capital, and then follow usual steps of calculating the payback period.
- Additional complexity arises when the cash flow changes sign several times (i.e., it contains outflows in the midst or at the end of the project lifetime). The modified payback period algorithm may be applied.
TERMS
- payback period
the amount of time required for the return on an investment to return the sum of the original investment
- cumulative
having priority rights to receive a dividend that accrue until paid
- discounted payback period
The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.
Payback period in capital budgeting refers to the period of time required for the returnon an investment to "repay" the sum of the original investment.
Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.
To calculate a more exact payback period:
Payback Period = Amount to be initially invested / Estimated Annual Net Cash Inflow.
Payback period method does not take into account the time value of money. Some businesses modified this method by adding the time value of money to get the discounted payback period. They discount the cash inflows of the project by a chosen discount rate (cost of capital), and then follow usual steps of calculating the payback period.
Discount rate: Discount rate set by Central Bank of Russia in 1992-2009.
Additional complexity arises when the cash flow changes sign several times (i.e., it contains outflows in the midst or at the end of the project lifetime). The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback period is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow.
Let's take a look at one example. Year 0: -1000, year 1: 4000, year 2: -5000, year 3: 6000, year 4: -6000, year 5: 7000. The sum of all cash outflows = 1000 + 5000 + 6000 = 12000.
The modified payback period is in year 5, since the cumulative positive cash flows (17000) exceeds the total cash outflows (12000) in year 5. To be more detailed, the payback period would be: 4 + 2/7 = 4.29 year.
