The payback period is the time it takes for an investment to generate enough net cash inflows to recover its initial cost. If a machine costs $100,000 and saves the business $25,000 a year, its payback period is four years. Managers use payback as a quick screening tool in capital budgeting, especially for smaller projects or when cash is tight and they want money back quickly.
Payback is easy to calculate and understand, and it gives a rough sense of risk: the sooner an investment pays for itself, the less exposed the business is to uncertainty about later years. However, it ignores the time value of money and any cash flows after the payback point, so it is usually used alongside measures such as net present value (NPV) and the internal rate of return (IRR) rather than on its own.
How the payback period is calculated
When cash inflows are the same each year, the formula is:
Here is the upfront cash cost of the project, and is the yearly cash generated, such as extra revenue or cost savings after operating costs and taxes. Depreciation is not deducted, because it is not a cash outflow.
When inflows vary, the payback period is found by adding up cumulative cash flows until they equal the investment.
Worked example
A bakery considers a $200,000 automated oven expected to generate these net cash inflows:
| Year | Cash inflow | Cumulative |
|---|---|---|
| 1 | $50,000 | $50,000 |
| 2 | $60,000 | $110,000 |
| 3 | $70,000 | $180,000 |
| 4 | $80,000 | $260,000 |
| 5 | $80,000 | $340,000 |
After three years, $180,000 has been recovered, leaving $20,000. Year four brings $80,000, so the remaining amount is recovered a quarter of the way through the year. The payback period is 3 plus 20,000 divided by 80,000, or 3.25 years. If the bakery requires payback within four years, the oven passes the test.
Discounted payback period
The discounted payback period addresses one weakness by discounting each year's cash flow at the company's required rate of return before adding them up. Using a 10 percent discount rate, the present values of the bakery's inflows are about $45,455, $49,587, $52,592, $54,641 and $49,674. Cumulative discounted cash flow reaches $147,633 after three years and $202,274 after four, so discounted payback is about 3 plus 52,367 divided by 54,641, or roughly 3.96 years. Discounted payback is always longer than simple payback when the rate is positive.
Strengths and limitations
- Payback is simple, intuitive and needs only cash flow estimates, not a cost of capital.
- It favors projects that return cash quickly, which helps companies with limited liquidity or in fast-changing industries where long-term forecasts are unreliable.
- It ignores cash flows after the payback point, so it can reject a project that pays back slowly but is very profitable overall.
- Simple payback ignores the time value of money, treating a dollar in year four the same as a dollar in year one.
- The cut-off period is chosen subjectively and has no direct link to shareholder value.
For these reasons, finance textbooks recommend NPV as the primary decision rule, with payback and the accounting rate of return as supplementary indicators. Surveys of corporate practice nonetheless find that payback remains one of the most widely used methods, often as a first filter before a project is compared with the company's hurdle rate.