What is the breakeven point if a business invests a given amount of money in a project? This is usually calculated by dividing the initial investment or cost into the net returns over a certain period. Payback Period Example – The capital expenditure for buying machinery may be £10,000, and this will bring about an expected return of £20,000 per annum for five years. The payback period would be five years [(£10,000/£20,000) x 5], i.e., two years.
In other words, it takes you two years to recover your initial investment and start making a profit.
The idea behind a payback period is that it should give you a rough indication of how long it will take before going into the profitable zone.
What is the meaning of the payback period?
The payback period is the time it takes a project to generate enough cash or net income to make back the original investment. For example, if you invest £100 in a project, and the project pays you back £105 at the end of a year, then your payback period has been one year.
What is the significance of the payback period?
Usually, businesses do not have unlimited funds, so they must prioritize which projects have access to their money. Companies measure this by using criteria such as return on investment or payback periods. Generally speaking, businesses will only finance projects with shorter paybacks than those requiring large sums of capital for long periods. In general, investors prefer short paybacks because they allow quicker recouping costs and reinvestment in other projects.
What are the advantages of using a payback period?
The payback period is vital to companies with limited funds because it allows them to prioritize their investments. A company can focus on short-term funding options, which will enable them to invest in future projects. It also allows managers to determine if the cash flow supports further development or if they need additional sources of capital.
How do you calculate the payback period?
The calculation for determining the payback period is simple: divide initial investment by total net returns over a given period. For example, if an entrepreneur invests $20,000 into a new business venture that yields $10,000 in the first year, they will receive $30,000 by year two. Therefore, their payback period is 1.5 years ($20,000/$30,000).
What are the limitations of using the payback period?
The payback period tends to favor projects with shorter investment periods because it does not consider future value or returns after the payback point. For example, if an entrepreneur invests $10 million into a project that yields $1 million per year for ten years (for a total return of $11 million), it would seem like this is a better deal than one that quickly pays back. However, even though the short-term project appears to be more profitable, it may yield less money in the long term.
To calculate the payback period, you need to know the following statistics:
1) Initial Investment (I) 2) Annual Cost Savings (C) 3) Number of Years (N). Then simply divide I by C and multiply it by N.
For example, if your initial investment is £2,000 and you expect an annual saving of £500 after three years, then simply : (£2,000/£500) x 3 = 6 years. This means that you will have saved enough money to pay back your initial outlay in six years.
Payback Period Calculation for Projected Cash Flows
The simplest way to estimate a payback period is through projected cash flows. To do this, you need to know the initial investment required, the average yearly savings, and the number of years you are planning to run your business venture.
For example, if an entrepreneur invests £67,000 in equipment with expected savings of £8,500 per annum for five years, then he can calculate his payback period as follows : (£67,000/£8,500) x 5 = 11 years. The investor will recuperate his money within 11 years or so.
It should be noted that this method does not consider whether these cash flows represent profits or sales revenue since it only compares cost against savings.
The Effects of Inflation on Payback Periods
To choose between several investment options, you can calculate the payback period for each of them. For example, if you have a choice between two investment options with an equal value of £100,000 and equal cash flows of £12,800 per annum, but one has a five-year payback, and in contrast, the other has a 15-year payback. Then in terms of simple calculations, your preference would be option one because, in general, people prefer shorter periods to recuperate their investments faster.
However, in real-life situations, this is not always true because inflation will play a significant role in reducing the value of money over time. In other words, when saying that it takes 15 years to break even after investing £100,000, it does not mean that you will make an equal amount of money after 15 years.
For example, inflation may be at 10 percent, so after 15 years, the value of your initial investment will only be £67,000 (10% x£100,000). In short, due to inflation, it takes you longer than 15 years to come out on top even though it seems that way because the payback period is more concise.
Financial Statements for Payback Period Calculations
When using projected cash flows or break-even points, special attention should be given to financial statements to make calculations relevant. For example, suppose a project requires an initial investment but comes from an investor who has promised further funds later on. In that case, this should also include these future investments, which are taken into account when calculating a payback period.
In the same way, if you have calculated your cash flows before taxes or depreciation, these should be taken into account to get a more accurate picture of the break-even point.
Example: Calculating payback period for equipment with varying savings
The cost of renting equipment is £75,000 per annum, and this brings about an expected saving of £20,000 per annum after three years. The cost of buying the same equipment is £120,000 with estimated protection of £21,900 per annum after three years.
The initial investment for renting is 1) (£75,000/£20,000) x 3 = 6 years 2) (£120,000/£21,900) x 3 = 9 years
The initial investment for buying the equipment instead is 1) (£120,000/£21,900) x 3 = 8 years 2) (£120,000/£20,000) x 3 = 10 years
In this example, both options have a payback period of fewer than five years, but option 1 has a shorter payback period. This is because the financial statements do not consider depreciation and tax, which would lead to lower cash flows in each case. Option one might be the wiser choice if these are included, depending on circumstances.
In Conclusion
There are many different methods to calculate payback periods depending on circumstances, and it is crucial to be aware of these when making critical business choices. Always use the most accurate procedure possible to make the most appropriate decision.