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How to calculate a payback period?

Published in Financial Metric 2 mins read

The payback period is a financial metric used to determine how long it takes for an investment to recoup its initial cost from the cash flows it generates. It's a simple way to assess the risk of a project, as shorter payback periods generally mean less risk.

How to Calculate the Payback Period

Based on the provided reference, the payback period is calculated using a straightforward formula:

Payback Period = Amount of Investment / Annual Cash Flow

This calculation assumes that the annual cash flow generated by the investment is consistent each year.

  • Amount of Investment: This is the initial cost required to undertake the project or acquire the asset.
  • Annual Cash Flow: This is the net cash generated by the investment each year.

Account and fund managers frequently use this calculation to quickly determine if an investment is worth pursuing.

Example Calculation

Let's look at a simple example to illustrate the calculation:

Item Value
Initial Investment Cost $50,000
Expected Annual Cash Flow $10,000

Using the formula:

Payback Period = $50,000 / $10,000

Payback Period = 5 years

In this example, it would take 5 years for the cash flows generated by the investment to equal the initial investment cost.

A Key Limitation

One significant aspect of the payback period calculation, as highlighted in the reference, is that it disregards the time value of money. This means it treats cash received in year 1 the same as cash received in year 5, ignoring factors like inflation or the potential for earning interest on money received sooner. While simple and quick, this limitation can make it less accurate for comparing projects with different cash flow timings, especially over longer periods.