You Have to Know Investment Payback Period
What is the investment payback period
The investment payback period is among the essential tools when it comes to financial modeling and forecasting for business development. It is a helpful guide in decision-making processes when you need to assess the attractiveness of the investment. This approach bases on evaluation of the cash outlay recovering velocity (without consideration of the time value of money).
Finmodelslab calculate the return per year from the beginning of the project and until the moment when the gross return equals the amount of the original investment. At this point, the investment is considered to be paid back. Accordingly, an investment payback period is the time required to reach the payback. Also, mention that the investment payback period indicates how rapidly the original investments recover. But is does not measure the long-term profitability of the project.
How do we calculate the investment payback period
The payback period is contingent upon two major factors: the cost of the project and the amount of the annual cashflows. If the expected annual inflows are even, the formula is as follows:
For instance, if a certain project requires a financial input of $1 million and is expected to produce a cashflow of $200,000 per year, then the investment payback period will be $1million/$200,000. It results in five years. In case the annual cash inflows vary, we need to accumulate the net cashflows per year. We do it until the point when they reach the amount of the initial investment. That year will be a payback year.
What else do you need to know about the payback period calculation
The more financial input the project requires and the less cashflows it produces, the longer period it takes to reach the cash outlay recovery. Generally, potential investors see shorter payback periods as more desirable.
However, sometimes the investment with a longer payback period may result in greater cumulative cash flow over time than the one with a short period of cash outlay recovery. It is evident that in order to get a meaningful result during the payback period calculation, we need to have accurate project cost estimation and cashflow forecast.
In order to implement the investment payback period technique in an Excel spreadsheet, we need the access to the individual numerical data. It is important to include the estimated amounts of cash flow and the cumulative cash flow. This allows the developer to find the point of cost recovery through the programmed logical test.
What is a typical payback period
The payback period as an approach to project acceptance assessment brings up a question about a threshold barrier at which investors consider the project attractive. Despite existence of considerable body of research on this topic, there is no common answer to this question.
In practice, it appears that usually the required payback period relates to subjective assessments, taking into consideration previous experience, as well as the perceived level of project risk. Typically, the managers consider this indicator of two to four years to be acceptable. But these figures can vary depending on the country and industry.
Some surveys regarding an optimal payback period carried out in the U.S. showed results of about two years, while one conducted in the U.K. reports that the perceived acceptable payback period for managers was almost three years. The minimum observed period by the researchers was one year, and the maximum, five years. The difference was also noticed interms of the industry. According to some believes, the new technology projects have longer payback periods than conventional projects.
Given that the payback periods vary in different countries and industries, businesses need to calculate it individually for every project. Such information is essential for managers during the decision-making processes. It helps them select the most profitable projects to invest in. Interested in effective allocation of your resources? Want to calculate the payback periods of your prospective projects? Or learn more about this method? Don’t hesitate to contact us here or via comments.
