## What is payback period, and why is it important?

The situation gets a bit more complicated if you'd like to consider the time value of money formula (see time value of money calculator). After all, your $100,000 will not be worth the same after ten years; in fact, it will be worth a lot less. Every year, your money will depreciate by a certain percentage, called the discount rate.## What Is the Decision Rule for a Discounted Payback Period?

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project. The payback period calculation doesn’t account for the time value of money or consider cash inflows beyond the payback period, which are still relevant for overall profitability. Therefore, businesses need to use other financial metrics in conjunction with payback period to make informed investment decisions.## Example of the Payback Method

However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management. This method provides a more realistic payback period by considering the diminished value of future cash flows.- Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased.
- The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even.
- Calculating payback period in Excel is a straightforward process that can help businesses make critical investment decisions.
- It's similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future.
- Under payback method, an investment project is accepted or rejected on the basis of payback period.

- The payback period equation also doesn’t take into account the effects an investment might have on the rest of the company’s operations.
- The payback period can apply to personal investments such as solar panels or property maintenance, or investments in equipment or other assets that a company might consider acquiring.
- For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years.
- Using the subtraction method, one starts by subtracting individual annual cash flows from the initial investment amount, and then does the division.