Payback Period PBP Formula Example Calculation Method

In Jim’s example, he has the option of purchasing equipment that will be paid back 40 weeks or 100 weeks. It’s obvious that he should choose the 40-week investment because after he earns his money back from the buffer, he can reinvest it in the sand blaster. Knowing the payback period is helpful if there’s a risk of a project ending in the future. For example, if a company might lose a lease or a contract, the sooner they can recoup any investments they’re making into their business the less risk they have of losing that capital. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.

Irregular Cash Flow Each Year

Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period.

Discounted Payback Period Calculation Analysis

Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. Jones-Albertus and Haenggi agree, there are a few scenarios when installing solar probably doesn’t make sense, no matter the payback period. If you know your roof will need to be replaced soon, you’ll definitely want to wait until that is done before you install solar panels on top of it.

Payback Period: Definition, Formula, and Calculation

•   Equity firms may calculate the payback period for potential investment in startups and other companies to ensure capital recoupment and understand risk-reward ratios. This method provides a more realistic payback period by considering the diminished value of future cash flows. This is a huge, but sometimes overlooked, factor in the solar payback period.

How to calculate your solar payback period

Basically, the higher the electricity rates where you live, the more lucrative solar can be for you. As utility rates increase, you save more money by relying on your solar panels instead of drawing power from the grid. Sometimes rooftop solar can completely cover your electricity payback period formula needs — reducing your utility bill to $0 — and sometimes it only covers a portion of it. If you consume a lot of electricity, solar might only translate to a small reduction in your electricity costs, which means it could take longer for you to see a return on your investment.

The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years).

Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows. At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The first step in calculating the payback period is to gather some critical information. However, a shorter payback period doesn’t necessarily mean an investment will generate a high return or that it is risk-free. Additionally, if the payback period is longer than the expected useful life of the project, the investment is not profitable.

• Financial modeling best practices require calculations to be transparent and easily auditable.
• Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile.
• These cash flows are then reduced by their present value factor to reflect the discounting process.
• The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project.
• Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment.

The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years. The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. Learn how to determine your solar payback period and find out when your investment will start saving you money. 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.

✝ To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. If you have any questions or need help getting started, SoFi has a team of professional financial advisors available to help you reach your personal financial goals. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.