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.
What you will learn
- 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
The formulas
- Initial investment
- amount paid upfront
- Annual cash flow
- equal cash inflow each year
- Y
- last full year before cumulative cash flow turns positive
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).
Common 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.