Calculate Payback Period Given Initial Cost And Cash Inflow

While starting any business venture or introducing any new product in the market, it is important to determine its payback period. The simple definition of payback period is the time that will be required for the initial investment to recover with the help of cash flow generated by business. In any business study, the first deciding point of launching any product is its payback period.

Calculating payback period is really easy and there is a very simple formula that you can use to calculate payback period given initial cost and cash inflow.

Payback Formula
Let’s assume that the cash inflow for each payback period even which makes it really easy to calculate the payback period with the help of following formula.

Payback Period = Initial Investment / Cash inflow per period

In case if the cash inflow per period is uneven then we will have to use a different formula to calculate payback period. The formula for uneven cash inflow is given below;

Payback Period = A + B/C

The variables used in above formula are described below;
•    A: Last period with a negative cumulative cash flow
•    B: Absolute value of cumulative cash flow at the end of the period A
•    C: Total cash flow during period A

With the help of following examples, you will be able to get a better understanding of above mentioned formulas.

Example 1: Even Cash Flows
Let’s assume that Company A is deciding to undertake a project that requires an initial investment of $100 million. The expected per annum income generated by project is estimated to be $25 million for next 7 years. The payback period of this project can be calculated by using the even payback period formula.

Payback Period = Initial Investment / Annual Cash Flow
Payback Period = $100M/ $25M
Payback Period = 4 Years
In above example, the project will recover its initial investment in first four years and the income generated in next three years will be considered as profit.

Example 2: Uneven Cash Flows
Let’s assume, Company A is taking a decision that involves undertaking a project that requires initial investment of $50 million and the expected income generated by project is $10 million for first year, $13 million for second year, $16 million for third year, $19 million for fourth year and $22 million for fifth year. The payback period of this project can be calculated with the help of uneven payback period formula as discussed above.

(cash flows in millions)    Cumulative
Cash Flow
Year    Cash Flow   
0    (50)    (50)
1    10    (40)
2    13    (27)
3    16    (11)
4    19    8
5    22    30

Payback Period
= 3 + (|-$11M| / $19M)
= 3 + ($11M / $19M)
≈ 3 + 0.58
≈ 3.58 years

It is really easy to calculate payback period for any project once you know about the initial investment and cash inflow values. Investors often use this method to determine whether it will be fruitful to invest their money in a particular project or not.

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What Is Payback Period And What It Means For Your Business

When it comes to running a business, there are a lot of things that you have to keep in mind. While you are introducing a new product range in the market, you have to consider the payback period of that product as well. Many people fail to understand that meaning of payback period or they don’t even consider it while launching a product. The end result becomes quite disastrous because if you have no idea about the payback period of a product/ service, you can never predict its future accurately.

In simple words, payback period is the time that is required to recover the original cash flow outlay in any business project. While evaluation an investment proposal, the most important factor considered is the payback period. An investor will only be interested in putting his money into your project if he sees the investment returning after a short period of time.

The payback period of a business that is producing a consistent annual cash flow can be calculated very easily with the help of initial investment. The relation between initial investment and annual cash flow is described below and the end result is called payback period.

Payback = Initial Investment / Annual Cash Flow

Payback period plays a vital role in the making and advancement of any organization. Below are some of the important reasons why a good payback period is important for any business.

Acceptance Rule

When it comes to rank different projects initiated within a particular field or by a particular company, the investment evaluation firms use payback period as a tool to rank the projects. There is a standard payback in every field and the investment evaluation firms compare the payback period of a project with the standard payback period. This way, they can easily tell how soon or later a project will recover the cost of its initial investment based on a standard value. The project that has the shortest payback period gets the highest ranking and the project with longest payback period gets the lowest ranking. This helps the investors to determine in which projects they want to put their money.

Advantages of Payback

While it takes hard work to lower the payback of a project and it involves a lot of planning as well, there are a lot of benefits that are associated with it.
Simplicity – As a startup firm, you will find it difficult to understand different economic values and how to calculate them. However calculating the payback period is not that difficult. Not only you can easily calculate the payback period of your venture but you can easily understand the process as well.
Cost Effective – There are different methods, techniques and criterions to determine the profitability of a business but they require a lot of work, analytical skills, man power and time. On the other hand, payback period can be easily evaluated by a single person, let it be the person who is starting that business. This makes payback criteria very cost effective criteria to evaluate the profitability of a business.

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