What Is Payback, What Is It For and How To Calculate It?

Payback is a financial indicator that represents the time needed to recover the initial investment through the cash flows generated by the project.

In other words, it shows just how long it will take a project or investment to “pay for itself” or recover the amount of money that has been invested.

Thus, by this calculation, one can know the period required for the profit he accumulates to equal the initial investment.

In this manner, the payback outcome is expressed in units of time, whether in days, months, or years.

For example, an entrepreneur says the payback period of a project is 3 years. That means that within the project payback period, it will take enough cash flow to recover the investment in terms of the initial investment. In other words, after this period, the project will start to generate net profit.

What is payback for?

In this sense, payback is mainly used by entrepreneurs and investors. Both use the indicator to analyze the viability of an investment according to its return period , but with different purposes.

The entrepreneur wants to know how long it will take to recover the money invested in new equipment, implementing a technology or opening a new branch, for example.

This way, with the aid of this calculation, he can determine whether it is worthwhile to wait for returns and carry on with the project or that it will take too long before recovering the cost to his cash flow.

The payback measures used by investors will determine the investment’s risks. It’s through this computation that the outcome therefore determines whether the expected return within the estimated time matches the investor’s risk margin and goals for their finances.

Investments with shorter payback periods are generally preferred as they reduce the period in which capital is exposed to uncertainty and allow earnings to be reinvested more quickly.

In addition to the previous examples, calculating payback can also be useful for:

Comparison of alternatives

When you have several investment options, the payback allows you to compare them based on the return time. In short, it helps you choose the most advantageous alternative in terms of liquidity.

Risk management

Additionally, payback can also be used to assess the risk associated with a project .

After all, the faster the return, the lower the risk of not recovering the investment.

Financial planning

The calculation provides a basis for financial planning and resource allocation, allowing managers to plan future cash flows and determine the viability of new projects.

Divestment decisions

Finally, payback is also used to decide when to discontinue a project that is not generating quick enough returns.

Learn about the types of payback

There are two types of payback widely used to assess the viability of investments. They are:

Simple payback

Also referred to as accounting payback , simple payback requires providing the recovery time for the amount invested. It is prompt and measures the level of investment risk, a very useful and relevant indicator under conditions requiring urgent decision-making.

However, this indicator does not consider the time value of money, ignoring the influence from the rate of inflation and interest rates.

Furthermore, it also does not consider cash flows that occur after the payback period .

Discounted payback

Although it’s very close to the previous one, discounted payback is more accurate.

This is because it makes use of a discount rate in calculating in consideration of the time value of money.
But this one’s a little complicated computation. Therefore, it requires more care in proper determination of a discount rate.

How to calculate: simple and discounted payback

Learn how to calculate simple and discounted payback based on the following explanation:

Simple calculation

Formula

Simple payback = Initial investment / Earnings in the period

Application

If you, as an entrepreneur, invested R$30,000 in a technology that generates a monthly return of R$2,000, the simple payback would be:

Simple Payback = 30,000 / 2,000

Simple payback = 15 months

Discounted calculation

Formula

Discounted payback = Initial investment / Discounted cash flow

Application

Here, the application is a little more laborious. After all, the discounted calculation makes the necessary monetary correction for each specific situation.

Therefore, it is necessary to integrate two fundamental concepts into the calculation. They are:

• Minimum Attractive Rate (MAR): minimum rate of return expected to be obtained from an investment, considering the associated risk.
• The difference between the original investment and the present value of future cash flows is known as net present value, or NPV.

Therefore, to calculate the NPV we have a new formula that must be incorporated into the previous equation:

Discounted value = Cash flow / (1 + MARR)¹

Imagine that your company has a cash flow of R$30,000 and a MARR of 15%. In this case:

Discounted value = 30,000 / (1 + 0.15)¹

Discounted value = 30,000 / (1.15)¹

Discounted amount = 26,086.95 (approximately)

Next, suppose the initial investment in this project was R$90,000:

Discounted payback = 90,000 / 26,086.95

Discounted payback = 3.45

In other words, the discounted payback value is around 3 and a half years.

Other financial indicators

There is another aspect of payback and other financial indicators that help to evaluate the viability and profitability of projects and investments. The most often applied among these is as follows:

Internal Rate of Return (IRR)

The IRR is that interest rate which would make the Net Present Value (NPV) of all cash flows from a project equal to zero. Thus, it is the rate that is expected as a return to make the investment present value neutral.

It is related to payback , as both assess the viability of an investment.

Return on Investment (ROI)

ROI is a type of financial indicator used to compare the effectiveness of many investments or assess how efficient an investment is. It calculates the yield in proportion to the investment’s cost. It is the payback that measures when this return will occur.