Payback Period Calculator

Cash Flow

Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator. The study of cash flow provides a general indication of solvency; generally, having adequate cash reserves is a positive sign of financial health for an individual or organization.

Discounted Cash Flow

Discounted cash flow (DCF) is a valuation method commonly used to estimate investment opportunities using the concept of the time value of money, which is a theory that states that money today is worth more than money tomorrow. Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows. WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted. For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments. WACC can be used in place of discount rate for either of the calculations.

Discount Rate

Discount rate is sometimes described as an inverse interest rate. It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments. For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes.

Payback Period

Payback period, which is used most often in capital budgeting, is the period of time required to reach the break-even point (the point at which positive cash flows and negative cash flows equal each other, resulting in zero) of an investment based on cash flow. For instance, a $2,000 investment at the start of the first year that returns $1,500 after the first year and $500 at the end of the second year has a two-year payback period. As a rule of thumb, the shorter the payback period, the better for an investment. Any investments with longer payback periods are generally not as enticing.

The formula to calculate payback period is:
Payback Period = Initial investment / Cash flow per year

Discounted Payback Period

A limitation of payback period is that it does not consider the time value of money. The discounted payback period (DPP), which is the period of time required to reach the break-even point based on a net present value (NPV) of the cash flow, accounts for this limitation. Unlike payback period, DPP reflects the amount of time necessary to break-even in a project based not only on what cash flows occur, but when they occur and the prevailing rate of return in the market, or the period in which the cumulative net present value of a project equals zero all while accounting for the time value of money. Discounted payback period is useful in that it helps determine the profitability of investments in a very specific way: if the discounted payback period is less than its useful life (estimated lifespan) or any predetermined time, the investment is viable. Conversely, if it’s greater, the investment generally should not be considered. Comparing the DPP of different investments, ones with the relatively shorter DPPs are generally more enticing because they take less time to break-even.

The formula for discounted payback period is:
Discounted Payback Period = -ln(1 – (investment amount × discount rate / cash flow per year)) / ln(1 + discount rate)