Payback Period Explained, With the Formula and How to Calculate It

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Payback Period Explained, With the Formula and How to Calculate It

payback period formula

However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. PBP is defined by calculating the time needed (usually expressed in years) to recover an investment. The PBP of a certain safety investment is a possible determinant of whether to proceed with the safety project, because longer PBPs are typically not desirable for some companies. It should be noted that PBP ignores any benefits that occur after the determined time period and does not measure profitability. Moreover, neither time value of money nor opportunity costs are taken into account in the concept.

For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month. The break-even point focuses on the amount of revenue required to achieve a no-profit, no-loss scenario. This metric considers the amount of money required to start seeing a return on investment rather than the length of time it will take a company to start making a financial gain. However, the length of the payback period depends on several factors, including the type of project, the size of the project, and the expected return on investment. If a project is large enough to require multiple phases, each phase may have a different payback period. In addition, some types of projects can take longer to complete than others.

When is the payback period favourable?

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. Cathy currently owns a small manufacturing business that produces 5,000 cashmere scarfs each year. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year.

What is NPV method?

Key Takeaways. Net present value (NPV) is used to calculate the current value of a future stream of payments from a company, project, or investment. To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a discount rate equal to the minimum acceptable rate of return.

Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. You can calculate the payback period by accumulating the net cash flow from the the initial Law Firm Bookkeeping 101 negative cash outflow, until the cumulative cash flow is a positive number. When the cumulative cash flow becomes positive, this is your payback year. Calculate the discounted payback period of this project if Mr Smith is using a discount rate of 10%.

What is the Payback Method?

Eventually, the customer pays back all of their CAC, shown here when the line crossed the x-axis. Once the cost of the investment is covered, then the customer's payment can go toward the company's growth. It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments.

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