How to Determine the Payback Period on Investments
The payback period is the number of periods it will take to pay back the initial investment on a piece of capital. In other words, it’s the number of years it will take for a corporation to break even on its new capital investment.
The payback period is a crucial calculation not only for projecting the cash flows, interest payments, and other value management techniques for the investment, but also for projecting the influence of the project on the entire corporation’s asset management and profitability. It’s calculated like this:
Payback period = Initial investment/Net annual cash flows
Start with your initial investment; then just divide it by your average net cash flows. For example, say you spend $10,000 on a piece of capital. This piece of capital will generate, on average, an extra $1,000 in EBIT to your corporation and has a lifespan of 20 years.
The calculation to figure out your payback period on this piece of equipment looks like this: 10,000/1,000 = 10 years. It will take you ten years to repay the investment on capital. Those net cash flows generated from the remaining ten years of the life of the investment are pure profit. Nicely done!
This calculation assumes, of course, that the initial investment is made all at once. It doesn’t have to be, though. For very large investments, you can take the future value of all amortization payments and use that as your initial investment.
In other words, if you have an investment that’s so large you need to finance it and repay the investment over the course of many years, just add up all the negative cash flows. This process of spreading out the payments of a cost is called amortization.
Calculating the payback period for an amortized investment only works with fixed interest rates, though, where the nominal amount you repay isn’t going to change over time. With variable rate loans, the calculation becomes a little trickier mathematically and is beyond the scope of this book.