The Payback period determines how long it takes for a project to reach a breakeven point
Payback Period = Initial Investment/Annual Cash Savings
You compare the initial investment with the net cash flows from the project over the expected benefits life of the project.
Shorter payback periods are preferred over longer periods.
This is a very simple technique to use which leads to its popularity
Let’s look at a simple implementation of the technique using Excel.
A project requires an initial investment of $200,000 and will generate cash savings of $75,000 each year for the next five years. What is the payback period? Click here to see the solution in Excel payback-period-example If you put your mouse cursor on each cell you will be able to see how it was determined.
The project begins to accumulate positive cumulative cash flow in the third year. If cash flows are realized only at the end of the year then the payback period is 3 years. On other hand, if the cash flows are received evenly during the year then, divide the cumulative amount by the cash flow amount in the third year and subtract from 3 to find out the moment the project breaks even. In this case the payback period is 3- (25000/75000) = 2.67 years.
What is an obvious limitation of this technique?