Calculating Payback Period
The payback period is how long it will take to recover money invested in a project, and the so-called straight-payback-period calculation is the simplest way of determining the project's investment potential. The result is expressed in time, and tells management how many months or years it will take to recover the original cost of the project, always a vital consideration, and especially so for managements evaluating several projects at the same time.
This evaluation becomes even more important if it includes an examination of what the present value of future revenue will be.
The straight payback period formula is:
Thus, if a project cost $100,000 and was expected to generate $28,000 a year, the payback period would be:
If the net revenue generated by the project is expected to vary from year to year, add the net revenues expected for each succeeding year until the total cost of the project is reached.
| Net Revenue | Total | |
| Year One | $19,000 | $19,000 |
| Year Two | $25,000 | $44,000 |
| Year Three | $30,000 | $74,000 |
| Year Four | $30,000 | $104,000 |
| Year Five | $30,000 | $134,000 |
In this example the project would be fully paid for in Year Four, when total net revenue surpasses the initial cost of $100,000. The exact payback period would be three years and 316 days.
The picture becomes complex when the time value of money is introduced into the calculations. Some analysts insist this is essential to determine the most accurate payback period. Present-value tables or computers (now the norm) must be used in this calculation, and the annual net revenues have to be discounted by the applicable interest rate, 10% in this example. Doing so produces significantly different results:
| Net Revenue | Present Value | Total | |
| Year One | $19,000 | $17,271 | $17,271 |
| Year Two | $25,000 | $20,650 | $37,921 |
| Year Three | $30,000 | $22,530 | $60,451 |
| Year Four | $30,000 | $20,490 | $80,941 |
| Year Five | $30,000 | $18,630 | $99,571 |
This computation indicates that payback would not occur even after five years.
- The straight payback period method can be misleading in that it ignores the time value of money, which, in turn, can produce unrealistic expectations. It also ignores any benefits generated after the payback period, and so a project that may return $1 million after, say, six years, may not be pursued.
- Usually, projects with shorter payback periods rank higher than those with longer paybacks, even if higher returns ultimately are projected for them, as they enable companies to recover an investment sooner and put it to work elsewhere.
- Generally, a payback period of no more than three years is desirable, while a project offering a payback period of no more than one year would be ranked essential.
Financial toolkit: www.toolkit.cch.com