Payback period

What it means

The payback period tells how many years it takes for an investment to be repaid from the money it generates. It is calculated by adding the project’s annual cash flows, meaning savings or extra income, against the amount invested until the total evens out.

The simple payback period ignores the time value of money; the discounted payback period converts the flows with a discount rate and comes out longer. The measure is popular because everyone understands it and it can be compared with the life of the investment.

Payback speaks to risk and liquidity, not to profitability. A project with a shorter payback returns the money sooner but does not necessarily earn the most. We therefore complement it with ROI, NPV or IRR.

How it works in practice

We calculate it most often for clients’ cost-saving investments, such as a new machine, software or energy measures. The flows include the tax effect of depreciation and any grant, which can shorten the payback considerably.

Where the investment is financed with a loan, we compare the payback period with the loan term. If the investment pays back more slowly than the instalments fall due, the company must cover the gap from other activities, and that has to go into the cash plan.

Banks and investors want to see it in a feasibility study together with the break-even point. For a small company it is often the deciding criterion, because an investment paying back over more than a few years is usually too risky for it.

What to watch out for

The simple payback period ignores everything that comes after it is reached. A project that pays back in three years and then ends can look better than one that pays back in four years but keeps earning for another ten.

A common mistake is using revenue instead of net benefit. Only incremental income and savings after the project’s running costs and taxes belong in the flows; otherwise the payback comes out optimistic and the company buys something that never pays for itself.