Payback period is the time in which project recovers its investment expenditures. For instance, set of solar panels may provide free operations onward but its installation cost is really high and it can take years or even decades to recover the initial cost. Payback period is a widely used term in the investment areas and in capital budgeting it refers as the period of time required to get return on investment to repay the sum of original investment. For instance, if you have invested $10,000 with return of $2,500 per year then your payback period is 4 years. Payback period helps you to measure the period of time in which you will get back your original investment. Payback period is widely used to know the advantages and disadvantages of an investment. Usually shorter payback periods are preferred to longer payback periods. Payback period is considered as effective way for the analysis of time value of money, risk, financing and other important contemplation like opportunity cost.
Procedure to Calculate Payback Period
Payback period is expressed in years and its calculations are also started with net cash flow for each year, just like:
Net Cash Flow Year 1 = Cash Inflow Year 1 – Cash Outflow Year1
Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 … etc.
You have to accumulate everything by year to get positive number as a Cumulative Cash Flow to get payback period. In order to calculate more exact payback period you have to use following formula.
Payback Period = Amount to be Invested / Estimated Annual Net Cash Flow 1
Following formula can also be used to calculate payback period:
Payback Period = (p – n) / p + ny
= 1 + ny – n / p (unit : years)
In this formula:
- Ny = It reflects number of years after the initial investment that reflects the last negative value of cumulative cash flow.
- N = It represents the value of cash flow at which last negative value of cumulative cash flow occurs.
- P = It represents the value of cash flow at which the first positive value of cumulative cash flow occurs.
Here is a useful free Payback Period Calculator created using MS Excel to help you quickly,
Payback Period for A Project
Determine the cost of project by adding all costs and expenditures. For instance, if you are working on the project of solar panels then you have to count the cost of panel and labor of installation. Calculate the difference between monthly expenditures after the completion of projects and name this monthly difference as D.
Suppose the cost of panel is $100,000 with electricity cost -$1000 per month because you are selling energy back to the grid. Consider that you were paying $2000 in electrical before the project then D is 2000 – (-1000) = $3000.
C – nD = o to determine how many months, n, must pass to break even. This is will help you get payback period. Suppose that C is $100,000 then the n = C/D = 100,000/3000 = 33.3 months or 2.7 years.
Time Value of Money
You can further get the time value of money with the help of following formula:
C = D [1 – 1 / (1+i) ^ n] / i
Here is download link of above mentioned Payback Period Calculator,