Tag: Payback PeriodListed here are financial model templates for different industries which includes a Payback Period section. The Payback period is the time required in order that an investment can repay its original costs in form of profit contributions or savings.
Payback Period – Definition and Purpose
The Payback Period is the time period required to recover the cost of a project. In other words, it is the length of time needed to know when a project's cash flows will be able to pay back for its initial investment. Whereas in capital budgeting, it refers to the period of time required to recover the funds expended in an investment or to reach the break-even point. The time value of money is not taken into account since the payback period intuitively measures how long a project can pay for itself. Once the payback period is determined, the shorter the duration of the payback period is, the more preferable it is compared to longer payback periods.
The payback period is usually expressed in years and a very important factor if you want to measure the feasibility of a project or investment. It is considered as a great tool of analysis which is often used due to its easy application and very easy to understand calculation where even entities that aren’t knowledgeable in finance will have an idea of the given report. Though it has serious limitations and qualifications for its use, such as not considering the time value of money, risks, benefits, financing, etc.; the payback period is still a reliable tool for comparing similar investments or projects. On its own, it’s not ideal, but together with other calculations such as the net present value and internal rate of return, discounted cash flow, etc., the payback period analysis will be really helpful to determine a more solid report of a project's feasibility. The real goal of calculating the payback period is to ensure that the project or investment will be able to continue even after the payback period.
What is a Dynamic Payback Period Method
Another variation in calculating the payback period is the dynamic payback period method or also known as the discounted payback period (DPP). In this method, you combine the basic approach of static payback period method with the discounting cash flow used for the NPV model to get the resulting payback period. Basically, a dynamic payback period is the period after which the capital invested has been recovered after considering the discounted net cash inflows from the project.
Compared to the static payback period method which is a much simpler approach to calculating the payback period, the dynamic payback period method takes account the time value of money just like the DCF method, but this does not necessarily mean that it will lead to the same results for absolute or relative profitability as the NPV method. One must remember that nothing is absolute and everything is subjective or dependent on the available data, such as designated time limit, cash flows, expenses, discount rate, etc.
In the end, a dynamic payback period method may differ when it comes to calculating the payback period compared to the normal method, but both work the same as it is used for evaluating a project or an investment on how long it will take for it to recover the costs incurred for the project or the initial investment.
How to Calculate Payback Period - Examples
Since the payback period is usually expressed in years, the steps for calculating the Payback Period is as follows:
When Even Cash Flows: PP = Initial Investment / Cash Inflow per Period
For Uneven Cash Flows: PP = A + (B / C)
A = The last period with a negative cumulative cash flow;
B = The absolute value of cumulative cash flow at the end of period A;
C = The total cash during the period after A
If we take the initial investment at its absolute value which is $1000, with the opening and closing period cumulative cash flows are $500 and $800, respectively. Assuming that the initial investment is recovered somewhere around 2-3 periods. We will then use the formula to calculate the payback period:
Payback Period = ( $1000 - $500 ) / ( $800 - $500 ) = 1.67
Thus, the payback period for this project is 3.67 years.
Of course, the formula has its drawbacks, such as:
- Can only be used to calculate the soonest payback period (first period once the investment has paid for itself)
- If cumulative cash flow drops after a positive cash flow previously, the payback period won’t be applied anymore
- Ignores values that arise after the payback period has been reached
- Can’t represent the true value of a project since it doesn’t take the time value of money into consideration
- Only focuses on short-term profitability
- Only shows the time period when the investment will be recovered but not the amount of return on investment
Therefore, it is evident that even though it has its own advantages, one must also consider its disadvantages and not only rely upon using the payback period to calculate a project’s or an investment’s feasibility. Given its nature, the payback period is usually used for initial analysis which is easy to calculate and easy to understand. Though it is used just like Breakeven Analysis, instead of considering the number of units to cover the fixed costs, it considers the amount of the time required to recover the investment. Even if it sounds simple and easy, one must also take note that it is only best for initial calculating the feasibility of a project.
Payback Period Example Models
To help you better understand how a payback period is calculated and work in a project financial model, you can refer to the above Payback Period Example Models. Made by financial modeling experts with vast experience and industry know-how, the payback period example models will serve as your base to start with when creating a model of a project or investment and determine if it is feasible or not. The listed payback period example models above all include payback period calculations for you to use as reference and learn how it works.