Payback Period
Payback period is the time or period it will take to obtain the amount of initial investment invested on a given project or investment. The periods can be in months, quarters or years, but more often years are the most commonly used periods.
Based on this simple definition of the payback period, it is obvious that the major influential factors in payback period are: the amount invested and the periodic cash flows from the investment.
Thus, the important information to know before computing for payback period is the initial investment amount and the cash flows for each period. For one to obtain the number of periods, first one has to know or have a projection of how much are the net cash flows that a given investment will generate back in every period.
For example, if Company X plans to invest in a project costing $100,000 as the initial investments, and the company expects an annual net cash flow of $20,000 per year, what will be the payback period of the investment?
A simple illustration of how company X will get its money back is as follows:
| Year | Net cash Flow | Total Net Cash Flow |
|---|---|---|
| First year | $20,000 | $20,000 |
| Second year | $20,000 | $40,000 |
| Third year | $20,000 | $60,000 |
| Fourth year | $20,000 | $80,000 |
| Fifth year | $20,000 | $100,000 |
The company will take five years to get back its $100,000 investment.
Payback Period Formula
The formula for calculating the Payback period is;
Payback period = Amount invested ÷ Estimated Net Cash Flow per period.
Using the formula in our example, it will be;
Payback period = $100,000 ÷ $20,000 = 5
An important concept to note is that, sometimes you can get situations where the management or an investor has identified the amount to invest and the periods or number of years the management wants the company's money back, but wants to know the net cash flow for each period. This situation can be handled by using the formula above. Let us use company X above to tackle such a problem.
Using the same example, the management of company X want to invest $100,000 and get it back in regular annual intervals for five years, how much will be Company X's annual expected net cash flow?
Payback period = Amount invested ÷ Net Cash Flow per period
Net Cash Flow per period = Amount invested ÷ Payback period
Net Cash Flow = $100,000 ÷ 5 = $20,000
Using the same example, we can see that the payback formula is very important to obtain the required amounts. The important thing is to note and understand the Payback formula and then substitute the elements with the appropriate figures and then solving for the required amount.