Calculate how long it takes to recover your investment. Determine both simple and discounted payback periods for capital budgeting decisions.
Investment recovered in 3.25 years
| Year | Cash flow | Cumulative |
|---|---|---|
| 0 | -$100,000 | -$100,000 |
| 0 | $0 | -$100,000 |
| 1 | $25,000 | -$75,000 |
| 2 | $30,000 | -$45,000 |
| 3 | $35,000 | -$10,000 |
| 4 | $40,000 | $30,000 |
| 5 | $45,000 | $75,000 |
Payback period is the time required to recover the cost of an investment. It's one of the simplest and most intuitive capital budgeting metrics, answering the fundamental question: "How long until I get my money back?"
Despite its simplicity, payback period remains popular in business because it addresses two key concerns: liquidity (how quickly can I access my capital again?) and risk (shorter payback means less exposure to uncertainty).
When cash flows are equal each period:
Example: $100,000 investment with $25,000 annual cash flows:
When cash flows vary by period:
Example: $100,000 investment with varying cash flows:
| Year | Cash flow | Cumulative |
|---|---|---|
| 0 | -$100,000 | -$100,000 |
| 1 | $25,000 | -$75,000 |
| 2 | $30,000 | -$45,000 |
| 3 | $35,000 | -$10,000 |
| 4 | $40,000 | $30,000 |
Payback = 3 + ($10,000 / $40,000) = 3.25 years
Simple payback ignores the time value of money. Discounted payback period addresses this by using discounted cash flows:
Example at 10% discount rate:
| Year | Cash flow | Discounted CF | Cumulative discounted |
|---|---|---|---|
| 0 | -$100,000 | -$100,000 | -$100,000 |
| 1 | $25,000 | $22,727 | -$77,273 |
| 2 | $30,000 | $24,793 | -$52,480 |
| 3 | $35,000 | $26,296 | -$26,184 |
| 4 | $40,000 | $27,321 | $1,137 |
Discounted payback = 3 + ($26,184 / $27,321) = 3.96 years
The discounted payback is always longer than simple payback (assuming positive discount rate).
Shorter payback periods are generally preferred because they:
| Industry | Typical acceptable payback |
|---|---|
| Technology | 2-3 years |
| Manufacturing | 3-5 years |
| Infrastructure | 5-10 years |
| Energy projects | 7-15 years |
| Real estate | 10-20 years |
Many companies set maximum payback thresholds — projects exceeding the limit are rejected.
| Metric | Strengths | Weaknesses |
|---|---|---|
| Payback | Simple, liquidity-focused | Ignores cash flows after payback |
| Discounted payback | Accounts for time value | Still ignores post-payback cash flows |
| NPV | Considers all cash flows | Harder to interpret |
| IRR | Percentage return | Multiple IRR issues |
Consider two projects with the same payback but different total returns:
| Year | Project A | Project B |
|---|---|---|
| 0 | -$100,000 | -$100,000 |
| 1 | $100,000 | $100,000 |
| 2 | $0 | $100,000 |
| 3 | $0 | $100,000 |
| Payback | 1 year | 1 year |
| Total return | $0 | $200,000 |
Both have the same payback, but Project B is clearly superior.
$100,000 received in year 1 is worth more than $100,000 in year 5, but simple payback treats them equally.
Choosing a maximum payback period is subjective and may reject profitable projects or accept poor ones.
A 2-year payback sounds good, but what if the total return is only 5%? NPV and IRR provide better profitability measures.
Should you buy a $50,000 machine that saves $15,000 annually?
Solar panels costing $25,000 with $3,000 annual savings:
$200,000 software investment with $80,000 annual efficiency gains:
$50,000 campaign expected to generate $20,000 monthly in additional profit: