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One way corporate financial analysts do this is with the payback period. The discounted payback period is a projection of the time it will take to receive a full recovery on an investment that has an accompanying discount rate. Similar to a break-even analysis, the payback period is an important https://accounting-services.net/20-best-accounting-software-for-nonprofits-in-2023/ metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business.

Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries.

## 3.2 Payback Period

A payback period is the amount of time needed to earn back the cost of an investment. Note that period 0 doesn’t need to be discounted because that is the initial investment. Now, we can take the results from this equation and move on to the next step. Before you invest thousands in any asset, be sure you calculate your payback period.

However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. By the end of Year 4 the project has generated a positive cumulative cash flow of £250,000. Typically, payback period is calculated across a whole business, by totaling all customer acquisition costs in a period, and dividing by revenue contributed by new customers for the following period. The payback period is an essential assessment during the calculation of return from a particular project. It is advisable not to use the tool as the only option for decision-making. During similar kinds of investments, however, a paired comparison is useful.bat.

## Discounted Payback Period Formula

In closing, as shown in the completed output sheet, the break-even point occurs between Year 4 and Year 5. So, we take four years and then add ~0.26 ($1mm ÷ $3.7mm), which we can convert into months as roughly 3 months, or a quarter of a year (25% of 12 months). First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. 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. The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line.

### How to calculate rate of return?

You can calculate the rate of return on your investment by comparing the difference between its current value and its initial value, and then dividing the result by its initial value. Multiplying the result of that rate of return formula by 100 will net you your rate of return as a percentage.

The payback period will be the same whether or not you apply a discount rate.However, for a discounted cash flow project, the payback period changes when you apply a discount rate. This is because future cash flows are worth less than present cash flows. You’re How to set up as an independent contractor in the Czech Republic banking on the fact that this initial investment can at least come to a break-even point and hopefully produce positive cash flows in the future. If you don’t know how each acquisition affects your net cash flow, you’re sailing in a SaaS sea with no sails.

## What is the difference between the payback period and the discounted payback period?

The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. For example, if the building was purchased mid-year, the first year’s cash flow would be $36,000, while subsequent years would be $72,000.

- But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions.
- A regular payback period is an estimate of the length of time that it will take for an investment to generate enough cash flow to pay back the full amount of the cash invested.
- Examining the payback period is helpful to identify several investment opportunities that may be available.
- The concept of the payback period refers to the key metric used to determine the length of time a business investment takes to pay for itself.
- The payback period is a measure organizations use to determine the time needed to recover the initial investment in a business project.
- The table indicates that the real payback period is located somewhere between Year 4 and Year 5.