What is the payback period?
The payback period is the time it takes for the income generated from a business to offset the initial investment.
A company needs to know how profitable an investment is going to be, and to carry out an investment analysis, different elements need to be analyzed.
Suppose you are going to analyze how profitable an investment is.
I bet that something that you are going to wonder after knowing how much you are going to earn, is how long will it take to recover what you invested.
That is what I try to teach you in this article.
I would like you to know at the end of the article what is the time in which you will recover your investment.
Thus, you will be able to make the decision on whether the project is posible, or if it is not posible.
Now, I will explain how to calculate it.
Calculate the payback period
To calculate the payback period you have two ways:
averaging method
What you have to do is divide the initial investment between the cash flows (inputs).
It should be noted that this approach works best when cash flows are expected to remain stable in subsequent years.
Subtraction method.
To begin with, the subtraction method is used when the cash flows are different in each period.
So you have to discount each cash flow separately (in each period) to the initial investment.
You are going to discount it until you reach the period in which you are going to recover the investment.
It is important to highlight that in both cases, the calculation is based on cash flows.
The elabora to obtain the PRI is the following:
- a = is the immediately preceding year in which the investment is recovered.
- b = It is the initial investment.
- c = It is the sum of the cash flows until reaching the end of period a.
- d = It is the cash flow of the year in which the investment is recovered.
Example using the averaging method.
Let’s say you have a business and you spend $100,000 on a new machine.
During each of the next five years, the machine is expected to require $10,000 of maintenance costs (per year) and will generate $50,000.
Therefore, the annual net positive cash flows are expected to be $40,000.
Now, you initially invested $100,000 (to buy the machine you need).
So, you’re going to divide it by the annual cash inflow of $40,000 (the cash flows).
The result is a payback period of 2.5 years.
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