Payback Period Analysis

Understand how long it takes to recover your initial investment and use this metric to compare projects and manage risk.

12 min read Beginner

What is Payback Period?

The payback period is the time required for an investment to generate enough cash flows to recover its initial cost. It's one of the simplest capital budgeting techniques.

Core Question

How long until I get my money back?

The shorter the payback period, the faster you recover your investment and the lower your risk exposure.

Investment -$100,000

Year 1 +$40,000

Year 2 +$40,000

Year 3 +$20,000

Payback!

In this example, payback occurs at 2.5 years when cumulative cash flows equal the initial investment.

Simple Payback Period

When cash flows are equal each period, the calculation is straightforward division.

Simple Payback Formula

Payback Period = Initial Investment / Annual Cash Flow

Example: Even Cash Flows

Problem: A machine costs $120,000 and generates $30,000 per year. What's the payback period?

Given: Initial Investment = $120,000, Annual CF = $30,000

Formula: Payback = $120,000 / $30,000

Result: Payback Period = 4.0 years

You'll recover your investment in exactly 4 years.

Uneven Cash Flows

Real investments rarely have perfectly even cash flows. For uneven flows, you must track cumulative cash flows year by year.

Example: Uneven Cash Flows

Problem: Investment of $80,000 with varying annual returns. Find the payback period.

Year	Cash Flow	Cumulative CF	Remaining
0	-$80,000	-$80,000	$80,000
1	$25,000	-$55,000	$55,000
2	$30,000	-$25,000	$25,000
3	$35,000	+$10,000	Recovered!

Partial Year: $25,000 / $35,000 = 0.71 years

Result: Payback Period = 2.71 years

Discounted Payback Period

The discounted payback period accounts for the time value of money by discounting each cash flow before calculating cumulative totals.

Simple Payback

Easy to calculate
Ignores time value of money
Ignores cash flows after payback

Discounted Payback

Accounts for TVM
More realistic
Still ignores post-payback CF

Important: Discounted payback will always be longer than simple payback because discounted cash flows are smaller.

Advantages & Limitations

Advantages

Simple and easy to understand
Good for liquidity planning
Useful for risk assessment
Works well for uncertain long-term projections
Quick screening tool for projects

Limitations

Ignores profitability after payback
Simple version ignores time value of money
Doesn't measure total return
May reject profitable long-term investments
Arbitrary cutoff selection

Decision Rules

Accept If

Payback Period �?Target Period

e.g., Payback of 3 years when target is 5 years �?Accept

Reject If

Payback Period > Target Period

e.g., Payback of 7 years when target is 5 years �?Reject

Best Practice: Don't use payback period as your only decision criterion. Combine it with NPV and IRR for comprehensive analysis.