Payback Period in 6 Minutes
The payback period is how long it takes a project to earn back its initial cost. With equal yearly cash flows, divide the cost by the annual cash flow. With uneven cash flows, add them up year by year until the running total turns positive, then work out the fraction of the final year.
Payback period explained simply
The payback period is how long it takes to get a project's cost back from its cash flows. Add the cash year by year until it covers the cost, then take the fraction of the last year needed. In the example, a $10,000 project paying $3,000, $4,000 and $5,000 pays back in about 2.6 years.
What this payback period lesson covers
- What the payback period tells you about a project
- The payback formula for even cash flows
- How to use cumulative cash flows when amounts are uneven
- How to calculate the fraction of an in-between year
- Weaknesses of the payback method
Payback period formula, explained
- Initial investment
- amount paid upfront
- Annual cash flow
- equal cash inflow each year
- Y
- last full year before cumulative cash flow turns positive
How to calculate the payback period step by step (worked example)
A project costs $10,000 and returns $3,000, $4,000, $5,000 and $2,000 in years 1 to 4. What is the payback period?
- Cumulative after year 1: −10,000 + 3,000 = −7,000
- Cumulative after year 2: −7,000 + 4,000 = −3,000
- Year 3 brings in 5,000, so payback happens during year 3
- Fraction of year 3: 3,000 ÷ 5,000 = 0.6
- Payback = 2 + 0.6 = 2.6 years
Answer: Payback ≈ 2.6 years, or about 2 years and 7 months (0.6 × 12 = 7.2 months).
Payback vs discounted payback vs NPV
| Payback | Discounted payback | NPV | |
|---|---|---|---|
| Uses time value of money | No | Yes | Yes |
| Counts cash after the cut-off | No | No | Yes |
| In the example | About 2.6 years | About 3.15 years (at 10%) | About $1,156 (at 10%) |
| Best for | A quick liquidity and risk check | A stricter quick check | Measuring value added |
Is payback really too simple to use? David's take
Textbooks call payback crude because it ignores everything after the money comes back. That's true. But when trying something is cheap, a key question is how fast you get your money back so you can try the next thing. This project pays back in about 2.6 years. My advice is to stop over-preparing and under-trying. Payback is a fair quick check for that kind of world, and NPV is the deeper one.
From David's concept: Game Theory Matters Less When Failure Is Cheap. This is David's opinion, alongside the standard textbook answer above.
Harder payback questions
What does payback ignore in this example?
The $2,000 in Year 4, and part of Year 3's $5,000. Two projects can have the same payback but very different value after it.
If the company's cut-off is 3 years, does the project pass?
Yes: 2.6 years is within 3. But the cut-off itself is a judgment call, which is why payback works best alongside NPV.
Common payback period questions
What is the formula for payback period?
With equal annual cash flows, payback equals initial investment divided by annual cash flow. With uneven cash flows, count the full years until the cost is almost recovered, then add the unrecovered amount divided by the next year's cash flow.
Is a shorter payback period better?
Usually, yes. A shorter payback means you get your money back faster, which lowers risk and helps cash flow. Companies often set a maximum acceptable payback and reject projects that take longer.
What are the disadvantages of the payback period?
It ignores the time value of money and ignores any cash flows after the payback point. A project could pay back quickly but earn little overall, while a slower one creates far more value. That is why NPV is the better decision tool.
How do you convert a payback period into years and months?
Keep the whole number of years and multiply the decimal part by 12. For example, 2.6 years is 2 years plus 0.6 × 12 = 7.2 months, so about 2 years and 7 months.