A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period https://www.kelleysbookkeeping.com/ as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.

Example 1: Even Cash Flows

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its dual aspect concept of accounting production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000.

Payback Period Vs. Other Capital Budgeting Metrics

The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. Due to its ease of use, payback period is a common method used to express return on investments, though it is important to note it does not account for the time value of money. As a result, payback period is best used in conjunction with other metrics. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years.

Decision Rule

Payback periods, discounted payback periods, average returns, and investment plans may all be calculated using the Payback Period Calculator. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects.

Everything You Need To Master Financial Statement Modeling

However, it adds a layer of complexity to the basic model by introducing the total sum of all cash outflows and recording all positive cash inflows. Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. The payback period is an accounting metric in capital budgeting that refers to the amount of time it takes to recover the funds invested in a project or reach a break-even point.

Every year, your money will depreciate by a certain percentage, called the discount rate. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive.

You will also learn the payback period formula and analyze a step-by-step example of calculations. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company. In addition, the IRR assumes that the generated cash flows are reinvested at the generated rate.

1. In this article, we will explain the difference between the regular payback period and the discounted payback period.
2. Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money.
3. WACC can be used in place of discount rate for either of the calculations.
4. Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking.

As a result, it does not provide adjustments for what a cash flow will be worth now and in the future, nor does it make any provisions for collecting the money. That is, https://www.kelleysbookkeeping.com/a-small-business-guide-to-cost-centers/ a cash flow of $300 today is worth more than the same amount in 5 years time. It provides a straightforward and easy way for calculating even and uneven cash flows.