Payback Period

Fundamentals · Dec 5, 2019

The main purpose of any investment is to generate more money than the amount invested, the time it takes to do so is called the payback period (PBP) in capital budgeting. Payback period is wildly used by investors and entrepreneurs when they consider to open a new enterprise, invest in an existing business, or when they try to pick the best opportunity among two or more possible options. This approach to evaluate a project is the most intuitive one, however today it’s considered limited and outdated because it doesn’t take into consideration the time value of money (TVM), the opportunity cost, and other important factors.

In this article, we’ll explain the main idea behind the payback period, give a few simple examples of how this period can be calculated, and cover some common misconceptions about the payback period that many people have.

What is the Payback Period? Definition and Formula

To calculate the payback period, simply divide the annual net profit by your initial investment:

$$PP = \frac{I}{NP}$$

Where:

• PP: Payback Period
• I: Initial Investment
• NP: Annual Net Profit

So, if the initial investment (invested capital) was $500,000, and the net profit (positive cash inflows) from the project is$250,000, then the payback period would be 2 years:

$$\frac{500,000}{250,000} = 2\,years$$

In many cases, the payback period would be a number with a fraction, i.e. 1.3, 2.5, 3.8, etc. Where 2.5 means 2 years and 6 months.

Usage

The payback period model is mainly used in two scenarios:

• For a potential and new business
• For a certain investment or a project within the existing business

In both cases, the way the payback period is calculated is pretty much the same.

This concept is mainly used in finance and capital budgeting, but sometimes you may see it being used when the cost savings of energy efficiency technology need to be calculated so it’s not unusual to see this approach being used to evaluate power plants, for example.

Simple Explanation

The payback period simply shows how long would it take for a project to recover the full cost of an initial investment.

If the payback period is 1 year and the invested amount is $50,000, that means that this project has generated 100% of its initial capital ($50,000) after one year, and after that, this project may start to be profitable for an investor. If the payback period is 3, 5, or even more years, perhaps, this project shouldn’t be considered if there is a better alternative available that would pay off faster.

In a way, the concept of the payback period is similar to the return on assets (ROA) indicator. For example, the ROA of 5% means that it would require 20 (5/100%) years to get back all the initial investments.

Also, the payback period is closely related to the break-even point concept, as both models serve a similar purpose - to figure out when the project is going to generate net income and cover the initial investment. The difference between these two concepts is that the payback period is a broad concept that can be applied to many different areas, and the break-even point is used with very specific parameters (fixed costs, variable costs, etc.), mainly for the production and manufacturing industries.

Let’s say that Mary wants to open a new small business. She got tired working for a small salary on her daily retail job and she already learned a lot about the retail business and now it’s time to open her own small convenience store.

She was able to save $100,000 at this point and that’s her capital. For the sake of simplicity we’d say that she already calculated everything perfectly and here is what she’s got: • Capital requirements:$100,000
• Annual revenue: $50,000 • Annual expenses:$30,000
• Annual net profit: $20,000 ($50,000 - $30,000) What would be the payback period of her business in this case? $$\frac{100,000}{20,000} = 5\,years$$ Not bad! Of course, this oversimplified example is not that realistic. What usually happens with such a business is that the revenues tend to gradually grow from a low point in the beginning but a big portion of the expenses is fixed and it needs to be spent right from the start. In reality, the cash flows for each year will be different and the future cash flows can be very hard to predict. Example 2: Comparing Two Projects A common use of the payback period is when two or more projects are getting compared and the best one is chosen based on the calculation. Let’s imagine that a factory manager can do two things: • Action 1: create a new business with an investment of$500,000 which is expected to generate $10,000 in net income per year • Action 2: deposit all the capital of$500,000 to the bank at 3% interest

What would be the smart thing to do in this scenario?

At first, the business that generates $10,000 in net income per year looks fine, but it’s only until we calculate the return on the investment and the payback period for this case. The expected return of this new business is just 2% ($10,000 / $500,000 = 0.02) and the payback period is 50 years ($500,000 / $10,000 = 50). With that in mind, the second option, just depositing money to a bank at 3%, is much better. A shorter payback is obviously superior to a longer one, therefore, in this case, the best action would be to open a bank deposit. If an investor understands that the opportunity cost should also be taken into account, many low-profit business ideas can become less attractive. This example gets even more interesting when we consider the time value of money (TVM). The Time Value of Money (TVM) We’ll keep the same two options from the 2-nd example for this one, but let’s add one more thing to the picture - the time value of money (TVM). Money tend to lose its value every year due to inflation, but, when invested properly, it can gain value with time and the key here is that investments grow in a compounded manner. The compound interest applies to almost any kind of investment: a stock, a bank deposit, etc. The idea of the time value of money is that there is always an alternative place to allocate your capital and you should always consider alternative options. For instance, instead of spending money on a new business, that might, or might not turn profitable, an investor can simply purchase bonds with an interest of 2-3%, that will pay this interest with almost 100% certainty, not to mention some more risky (still less risky than opening a new business), but far more profitable options like buying the S&P 500 index. So, even if in the previous example the bank’s interest was lower than 2% (lower than the return of the business), say 1.75%, even then, the 2-nd action would be much better just because during these 50 years, while the business is taking off, the bank’s deposit will gain a value of$1,198,673 at the time when the business pays off. On the 50th year the 1-st investment in business will have the same value of $500,000 as in the beginning and generate 2% of the simple interest ($10,000), yet at this time the bank’s deposit will be valued at $1,000,000+ (because the interest is compounded) and generate 1.75% of the larger base amount ($17,500/year).

After all, even with the reduced interest of 1.75%, the bank’s deposit for $500,000 is far better than the business costing$500,000 to start, that generates a 2% rate of return just because the net income from that business is not compounded.

Plus, an initial investment in a business is almost always disappears forever while investment in a safe security holds its initial value and growth rate from the start. On paper, the initial investment in a business can partially be transferred to the assets part of the balance sheet and can even be sold if it’s something like equipment, but in this case it’s value usually gets reduced significantly.

This payback period that takes into account the time value of money is called the discounted payback period.

The exact calculation and the formula of the discounted payback period is a bit too complicated for this article, but it can be done in MS Excel quite easily. Here is a nice educational video by David Johnk on YouTube that shows how to calculate that.

What is a “Normal” Payback Period?

It’s quite hard to find reliable statistics of real payback periods by industry and sectors, many publications on this topic doesn’t seem legit. There are many reasons for that, after all, not all the financial data in a form of an annual report is publicly available, and one business might be different from one location to another depending of the quality of goods, number of customers, the rent cost and million other factors.

However, it’s obvious that some business would have short payback periods and others would take forever to break-even.

Generally speaking, a small, unique and niche business usually has a short payback period of 6 - 12 month up to 1 - 3 years. It could be a convenience store, an online startup or some niche farming. Banking has a very long payback period of 5, 10 or more years because of the nature of its business, and this is true for the manufacturing and production as well, but in some cases, a factory can break-even much faster if it produces a highly demanded product without much of the competition. Agricultural business historically had a very long payback period if any at all. Real estate business is not always as profitable or stable as many people believe, but in most cases its payback period is long, 20+ years, unless it’s bought on a hyped bull market at a good location.

So, as you can see, the “normal” payback period highly depends on the industry, but usually, for a small business, an entrepreneur expects it to be somewhere between 3 - 6 years in a developed and stable country, and 1 - 2 years in a developing nation. This period is different because a developed country usually has more competition in all industries and the markets are already full, but in a developing country a small business can grow much faster as the markets there are relatively empty, however, such a country has more risks as well.

One Common Problem With the Payback Period

The classic concept of the payback period has one major issue - it doesn’t take into account the time value of money. There is always an option to allocate the money in a bank or to buy a bond, in some cases even stock market investment would be a better option than to open a new business. It’s not to say that it’s always better to just invest your money or to buy an existing business rather than to open a new one, but in many cases, new entrepreneurs starting their business without taking the time value of money into consideration.

For more accurate calculation the discounted payback period, that takes into account the TVM, should be used. Plus, in a business plan, the simple payback period is often calculated with an assumption that all future revenues and expenses are known, fixed, and predicted, and that is simply not the case in the real world. The net profit could be predicted with a relative certainty only for an old business, that is why an option to just purchase an existing business is often more reliable than starting a new one.