Payback Period
Payback = Years before full recovery + (Unrecovered cost / Cash flow in recovery year)
How long it takes for a project's cash flows to repay the initial investment. Simple but ignores TVM.
Variables
Upfront outlay
Net cash inflows each year
Example Calculation
Scenario
Project costs $10,000. Cash flows: Year 1 = $4,000, Year 2 = $4,000, Year 3 = $3,000.
Given Data
Calculation
After Y1: $6,000 unrecovered. After Y2: $2,000 unrecovered. Y3 recovery: 2,000/3,000 = 0.67. Payback = 2.67 years.
Result
2.67 years
Interpretation
The project recoups the investment in about 2 years and 8 months.
When to Use This Formula
- ✓Quick screening of projects
- ✓When liquidity is the primary concern
- ✓Supplement to NPV analysis
Common Mistakes
- ✗Using payback as the sole decision criterion
- ✗Ignoring cash flows after the payback cutoff
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Common questions about this formula
Discounted payback fixes the TVM flaw by using present values, but still ignores post-cutoff cash flows.
It is simple, intuitive, and useful for liquidity screening. In industries with high uncertainty or rapid technological change, managers want to know how quickly they recover their investment, even if NPV is the primary decision tool.