Tag: Payback PeriodListed here are financial model templates for different industries which include a Payback Period section. The Payback period is the time required in order that an investment can repay its original costs in form of cash flow, profits or savings.
Financial model template for a high-level real estate brokerage firm that facilitates the buying and selling of real estate properties between buyers and sellers. Providing a sound financial plan and 5-yrs worth of financial projections…
This is a collection of financial model templates for businesses in the Information technology Industry and its related sectors.
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 cumulated cash flow will be able to pay back for its initial investment. Also, it is a question of risk where the shorter the money is invested in a risky project, the less risky the investment is. But the main advantage of this ratio is that it is easy to calculate and also can be easily understood by anybody.
The payback period is usually expressed in years or months and a very important factor if you want to measure the feasibility of a project or investment and its risk.
On the other hand, the limitation of this ratio is that in the simple form, it is not considering the time value of money and only focuses on short-term benefits. Basically, the cash flows at the beginning have the same weight as cash flows coming in the future. Also, cash flows after the project has paid back its investment are excluded from the analysis.
In other words, a payback period has very clear advantages and disadvantages such as:
+ Simple financial metric easy to calculate
+ Easy to explain
- Focus on Short-Term gains (excludes longer-term benefits from the analysis)
- Cash Flows in the near and distant future have the same weight
Overall, the payback period is a great and simple financial ratio to check whenever you consider an investment.
How to Calculate the Payback Period? - Example
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 the last negative cumulative cash flow at the end of period A;
C = The total cash flow received during the period after A
If we take the initial investment in the example above of $50M, you will see that in year 4 the cumulated cash flows become positive ($8M). This means the project's payback period is between year 3 and year 4. If we want to calculate it precisely, we need to divide the missing cash flow by end of year 3 (-$11M) by the cash flow received in year 4 ($19M).
Therefore, the payback period for this project is 3.6 (3 + 11/19) years.
The 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 check when the discounted free cash flows payback for its investment. 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 (and therefore the risk of the business) just like the DCF method.
In the end, normally the dynamic payback period leads to a longer time required to pay back for the investment compared to the normal payback calculation. This is due to the fact, that the positive cash flows in the future are discounted and therefore are reduced.
This method has similar drawbacks as the first method but can better include the project's risk by discounting the future cash flows for their risk as a function of time.
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 include payback period calculations for you to use as reference and learn how it works.