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How to Calculate Payback Period: Method & Formula

How to Calculate Payback Period: Method & Formula
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  • 0:02 What Is Payback Period?
  • 0:49 Even and Uneven Cash Flows
  • 4:01 Limitations of the…
  • 5:07 Lesson Summary
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Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

When making a decision regarding an investment, people and companies can compute the payback period to find out how long it will take to recover their initial investment. This lesson demonstrates how you can use this formula.

What Is a Payback Period?

The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income. When comparing two or more investments, business managers and investors will typically compare the projects to see which one has the shorter PBP. Projects with longer PBP are usually associated with higher risk.

For the purposes of this lesson, you will be a senior business manager for a large corporation and one of your responsibilities is to select from among the many potential projects that are proposed by employees and lower-level managers. Although the size of your company is big, there is not enough money to fund all of the projects and the board of directors wants you to ensure that the organization does not invest in risky ventures.

Even and Uneven Cash Flows

Before beginning to analyze the two proposed projects brought to your office, you notice that one project has even cash flows and the other has uneven cash flows. There are two different methods that you will need to use to see which one is the best choice for your company.

Even cash flows mean that the investment is expected to bring in income that is constant each year. The first investment is for a new machine that will produce one of your company's products more efficiently and will bring in the same income each month based on the organization's steady production of that item. The cost of the machine is $28,120, and it is expected to bring the company a net cash flow of $7,600 per year for the next fifteen years of the machine's useful life.

The formula you will use to compute a PBP with even cash flows is:

Payback Period - Even Cash Flows

By substituting the numbers into the formula, you divide the cost of the investment ($28,120) by the annual net cash flow ($7,600) to determine the expected payback period of 3.7 years.

PBP - Even with solution

Uneven cash flows occur when the annual cash flows are not the same amount each year. Under these circumstances, the formula that we used before will not work but being the wise business manager that you are, you still know how to figure out the PBP for this project.

The second investment is for a totally new product that can be made with most of the same machinery, but it will need some unique equipment and materials. Additionally, until the public is aware of the product's existence, there will not be a lot of demand for it. The first two columns of the table were provided by the business manager of that section based on her experience with new products of this type. You were able to add the right hand column that shows the cumulative net cash flows.

PBP Uneven Cash Flows

Cumulative cash flows are the running total added to the initial investment. Remember that the initial investment is a cash outflow and is shown as a negative number. Year zero is the first year that shows the amount of the initial investment, and each year afterwards has income that is added to find the cumulative net cash flow for that year. We see that in the chart, it takes over four years to pay back the initial investment.

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