What is the payback period?
The payback period is the time required to recover an investment’s cost. It is simply the time it takes for an investment to reach breakeven.
It plays a major role in the investment decisions of both individuals and companies. The shorter it is, the more attractive an investment becomes. Anyone can determine it by dividing the original investment by the average cash flow.
Understanding the Payback Period
The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. It helps determine how long it takes to recover the initial costs associated with an investment. This metric is useful before making any decisions, especially when an investor needs to make a snap judgment about an investment venture.
You can figure it out by using the following formula:
Payback Period = Average Annual Cash Flow / Cost of Investment
The shorter the payback, the more desirable the investment.
Conversely, the longer the payback, the less desirable it becomes. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good period as experts say it can take as much as 9- 10 years for residential homeowners in the United States to break even on their investment.1
Capital budgeting is a key activity in corporate finance. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period.
Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
