💬## Definition of a Payback Period

A payback period is the length of time a business expects to pass before it recovers its initial investment in a product or service.

Evaluating payback period helps companies recognize different investment opportunities and determine which product or project is most likely to recoup their cash in the shortest time. A fast return may not be a priority for every business in every case, but it’s a crucial consideration all the same.

Companies can calculate the payback period on an investment in two simple ways:

With this method, payback period is calculated by dividing the annualized cash inflows a project or product is expected to generate, by the initial expenditure.

When cash flows are forecasted to be steady, the averaging method can deliver an accurate idea of payback period. But if the company could encounter major growth in the near future, the payback period may be a little wide of the mark.

This formula starts by subtracting single annual cash inflows from the initial cash outflow. The subtraction method is most effective when cash flows are likely to fluctuate in the coming years, unlike with the averaging method.

Problem is, the payback periods only consider cash flows up to the point at which a company’s initial investment is regained — not subsequent earnings. As a result, a business may fail to see the long-term potential of a project if they focus too much on short-term ROI.

A product or service may require time to grow and reach a bigger audience through positive word of mouth, for example. Failing to acknowledge this potential could cause companies to overlook valuable opportunities.

Another issue is that a product or project can take longer to recoup investments than a company is happy with, but could still be good for the brand and its reputation overall. The payback period methodology fails to take this into account — emphasizing short-time gains instead.

All businesses need to consider depreciation within their accounting and forecasts, as it will impact the value of goods over time. However, depreciation isn’t a loss of value in cash terms — you haven’t actually lost physical money on that laptop you own, have you? Therefore, when calculating cash flows for payback periods, we need to add depreciation back into the equation. For example… If a product costs $1 million to build and makes a profit of $60,000 after depreciation of 10% but before tax at 30%, the payback period would be: Profit before tax = $60,000 Less tax = (60000 x 30%) = $18,000 Profit after tax = $42,000 Add depreciation = ($ 1 million x 10%) = $100,000 Total cash flow = $142,000 Payback period = Total investment ($ 1 million) / Total cash flow ($142,000) = 7 years (approximately)

How to calculate the payback period?

A business can calculate payback periods using two methods:
Averaging — This approach calculates payback periods by dividing a project or product’s expected yearly cash inflow by the initial expenditure. Averaging can create an accurate insight into payback periods but may become compromised if the business undergoes significant growth.
Subtraction — With this method, payback periods are calculated by subtracting single yearly cash inflows from the initial cash outflows (salaries, materials, etc.). This is an effective option when a company believes its cash flows will probably fluctuate down the line, as opposed to the averaging method discussed above.

How to calculate the discounted payback period?

A discounted payback period tells businesses how many years they can expect to wait until they break even on their initial investment, through discounting cash flows in the future and factoring in the time value of funds. Companies can use this metric to measure the profitability of a specific product or project.
You can calculate your discounted payback period by dividing the overall expense of a product or project by its average annual cash flows.

How does depreciation affect the calculation of a project's payback period?

Depreciation refers to how assets lose value over time, typically measured by a set percentage, e.g. 10% per year. After all, you may buy a laptop for $2,000 in 2020, but by 2022 it will be worth less (due to wear and tear, market changes, the evolution of technology, etc.)

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