How to calculate the payback period
/The payback period is the amount of time required for cash inflows generated by a project to offset its initial cash outflow. This calculation is useful for risk reduction analysis, since a project that generates a quick return is less risky than one that generates the same return over a longer period of time. There are two ways to calculate the payback period, which are described below.
Calculating Payback Using the Averaging Method
Using the averaging method, you should divide the annualized expected cash inflows into the expected initial expenditure for the asset. This approach works best when cash flows are expected to be steady in subsequent years.
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Calculating Payback Using the Subtraction Method
Using the subtraction method, subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved. This approach works best when cash flows are expected to vary in subsequent years. For example, a large increase in cash flows several years in the future could result in an inaccurate payback period if using the averaging method. It is also possible to create a more detailed version of the subtraction method, using discounted cash flows. It has the most realistic outcome, but requires more effort to complete.
Note that in both cases, the calculation is based on cash flows, not accounting net income (which is subject to non-cash adjustments).
Example of the Payback Period
Averaging method: ABC International expends $100,000 for a new machine, with all funds paid out when the machine is acquired. Over each of the next five years, the machine is expected to require $10,000 of annual maintenance costs, and will generate $50,000 of payments from customers. The net annual positive cash flows are therefore expected to be $40,000. When the $100,000 initial cash payment is divided by the $40,000 annual cash inflow, the result is a payback period of 2.5 years.
Subtraction method: Take the same scenario, except that the $200,000 of total positive cash flows are spread out as follows:
Year 1 = $0
Year 2 = $20,000
Year 3 = $30,000
Year 4 = $50,000
Year 5 = $100,000
In this case, we must subtract the expected cash inflows from the $100,000 initial expenditure for the first four years before completing the payback interval, because cash flows are delayed to such a large extent. Thus, the averaging method reveals a payback of 2.5 years, while the subtraction method shows a payback of 4.0 years.