Payback Period Calculator

Cash Flow

Cash flow is the money actually moving into and out of a business, project or household over a period. Positive cash flow means more cash arrived than left; negative cash flow means the reverse. It differs from accounting profit: a company can report a profit while running short of cash because customers have not paid yet, or show a loss on paper because of non-cash charges like depreciation while generating plenty of cash.

For evaluating an investment, the relevant figure is the extra cash the investment produces each year: added revenue or cost savings, minus added operating costs and taxes. That stream of yearly cash flows, compared against the up-front cost, is what payback analysis measures.

Discounted Cash Flow

A dollar received in five years is worth less than a dollar today, because today's dollar could be invested in the meantime. Discounted cash flow (DCF) analysis adjusts for that by converting each future cash flow to its present value: divide it by (1 + r)^t, where r is the discount rate and t the number of years until it arrives. At 10%, $30,000 received in year 1 is worth $27,272.73 today, and $30,000 in year 5 only $18,627.64.

Adding up the discounted inflows and subtracting the initial cost gives the net present value (NPV). A positive NPV means the investment earns more than the discount rate; a negative one means it earns less. DCF is the standard approach for valuing projects, businesses and stocks, though its answers are only as reliable as the cash flow forecasts and the discount rate behind them.

Discount Rate

The discount rate is the annual return you could reasonably expect elsewhere for taking similar risk, so it represents the opportunity cost of tying money up in this investment. Companies typically use their weighted average cost of capital (WACC), the blended cost of their debt and equity, sometimes raised for riskier projects. Individuals might use the interest rate on debt they could pay off instead or the long-run return they expect from a diversified portfolio. Higher discount rates shrink distant cash flows the most, so they lengthen discounted payback and favor projects that pay back quickly.

Payback Period

The payback period is the time it takes for an investment's cumulative cash flows to equal its initial cost. It is popular because it is intuitive and answers a practical question: how long is my money at risk? With even cash flows, divide the cost by the yearly cash flow; a $100,000 project returning $25,000 a year pays back in 4 years. With uneven flows, add up the cash flows year by year until the total passes the cost, then interpolate within the final year.

Using this page's default: $100,000 invested, $30,000 in year 1 growing 5% a year. Cumulative cash flow reaches $94,575 after three years, so $5,425 remains. Year 4 brings $34,728.75, and $5,425 ÷ $34,728.75 ≈ 0.16, for a payback period of about 3.16 years.

The method has clear weaknesses. It ignores the time value of money, and it ignores everything that happens after payback, so a project that pays back in 3 years and then stops looks better than one that pays back in 4 years and then earns for 20 more. Shorter is generally better, but payback is best treated as a risk and liquidity screen rather than a measure of profitability.

Payback period = A + B ÷ C

A

last full year before cumulative cash flow turns positive

B

amount still unrecovered at the end of year A

C

cash flow during the following year

For an even cash flow this reduces to Initial investment ÷ Annual cash flow. The discounted payback period uses the same steps with each cash flow divided by (1 + discount rate)^year.

Discounted Payback Period

The discounted payback period fixes the first weakness by working with present values. Each year's cash flow is discounted before being added to the running total, and payback occurs when the cumulative discounted cash flow reaches zero. Because discounting shrinks every future dollar, the discounted payback period is always longer than the simple one when the discount rate is positive. If the cumulative discounted cash flow never reaches zero within the project's life, the NPV is negative and the project does not earn its required return.

Continuing the example at a 10% discount rate, the year 1 cash flow of $30,000 is worth $27,272.73 today, year 2's $31,500 is worth $26,033.06, and so on. After three years the cumulative discounted total is $78,155.52, leaving $21,844.48 to recover. Year 4's discounted cash flow is $23,720.20, so discounted payback is 3 + 21,844.48 ÷ 23,720.20 ≈ 3.92 years. Over all five years, the discounted inflows sum to $124,517.74, for an NPV of $24,517.74.

Discounted payback still ignores what happens after the payback date, so it should be read alongside NPV and IRR. Its strength is that it tells you when an investment has not just returned your money, but returned it with the required rate of return. That makes it useful in industries where technology or markets change quickly and long-dated forecasts are unreliable, and for small businesses where cash tied up in a project could be needed elsewhere.

Rules of thumb vary. Many companies set a maximum acceptable payback, such as three or five years, for routine equipment; energy-efficiency upgrades and solar installations are often marketed by their payback period, commonly six to twelve years for residential solar in the US depending on local electricity prices and incentives.

Frequently asked questions

Sources

• U.S. Department of Energy – Energy Saver
• U.S. Small Business Administration