Payback Period

Payback Period is a financial metric that answer the question: How long does it take for an investment to pay for itself? Or, how long does it take for incoming retuns to cover costrs? Or, put still another way: How long does it take for the investment to break even?

Like other financial metrics such as  internal rate of return (IRR) and return on investment (ROI), payback period takes essentially an "Investment" view of the action, plan, or scenario and its estimated cash flow stream. Each of these metrics comparies investment costs to investment returns in one way or another. Payback period is the length of time required for cumulative incoming returns to equal the cumulative costs of an investment (e.g. purchase of computer software or hardware, training expenses, or new product development), usually measured in years.

Other things being equal, the investment with the shorter payback period is considered the better investment. The shorter payback period is preferred because: 

• The investment costs are recovered sooner and are available again for further use. 
• A shorter payback period is viewed as less risky. It is usually assumed that the longer the payback period, the more uncertain are the positive returns. For this reason, payback period is often used as a measure of risk, or a risk-related criterion that must be met before funds are spent. A company might decide, for instance, to undertake no major investments or expenditures that have a payback period over, say, 3 years. 

  Payback Period Example

  As an example, consider a five year investment whose cash flow consequences are summarized in the table below. The primary data for payback calculation are the expeected cash inflows and outflows from the investment: 
  • Cash Inflows: The investment will bring $300 cash inflow each year, for years 1 - 5.
  • Cash outflows: The intial cost of the investment is a cash outflow of $800 in year 1, followed by a cost (outflow) of $150 in year 2. There are no expected costs in years 3 - 5.
  From these figures, the analyst creates two sets of cash flow numbers to use for the calculation (the bottom two rows of the table):
  • Net Cash Flow. The net of cash inflows and outflows for each year.
  • Cumulative Cash Flow. The sum of all cash inflows and outflows for all preceding years and the current year. 

  Investment Cash Flow	Year 1	Year 2	Year 3	Year 4	Year 5
  Cash Inflows	300	300	300	300	300
  Cash Outflows	– 800	–150	0	0	0
  Net Cash Flow	– 500	150	300	300	300
  Cumulative Cash Flow	– 500	– 350	– 50	250	550

  When does payback occur? Look first to the cumulative cash flow line at the table bottom, and it is clear that payback occurs sometime in Year 4. We know that payback occurs in Year 4 because cumulative cash flow is negative at the end of Year 3 and positive at the end of Year 4. But where, precisely, is the payback event in Year 4? The answer can be seen roughly on a graph, showing the payback event as the "break even" point in time, when cumulative cash flow crosses from negative to positive:
  
  In reality, payback may occur any time in year 4, at the moment when the cumulative cash flow becomes 0. However, if the analyst has only annual cash flow data to work with (as in this example) and no further information about when cash flow appears within year 4, the analyst must assume the year's cash flows are spread evenly through the year. In this case, payback period has to be estimated by interpolation. That approach is illustrated here and in the next section. The assumption that cash flow is spread evenly through the years is represented by the straight lines between year end data points above.
  Using the tabled data above, where the payback year is clearly Year 4, payback period can be calculated (estimated) as follows;
  Payback Period = Y + ( A / B ) where
  Y = The number of years before final payback year. In the example, Y = 3.0 years. 
  A = Total remaining to be paid back at the start of the payback year, to bring cumulative cash flow to 0. In the example, A = $50.
  B = Total (net) paid back in the entire payback year. In the example, B = 300.
  For the example,
  Payback Period = 3+ (50) / (300)
  Payback Period = 3 + 1/6 = 3.17 Years
  Payback period calculated this way is an estimate, based on interpolation between two period end points (between the end of Year 3 and the end of Year 4). Interpolation was necessary because we have only annual cash flow data to work with.