How to calculate the payback period Definition & Formula

payback period equation

In order to calculate the discounted payback period, you first need to calculate the discounted cash flow for each period of the investment. IRR or internal rate of return is a financial metric used to determine the profitability of certain business investments. Most broadly speaking, the higher the IRR, the more desirable the investment opportunity is. IRR is calculated using the same formula as the net present value (NPV). Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period.

payback period equation

As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. The customer acquisition cost payback formula is used to measure the time it takes for a company to recoup the cost of acquiring a new customer through the gross margin generated by that customer. Your CAC payback period provides insight into when acquisition costs come back into the business.

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Failing to acknowledge this potential could cause companies to overlook valuable opportunities. Payback period tells us how long it takes to get back our capex from revenues/profits. NPV discounts future revenues and expenditure to reflect the fact that we care less about our money in the future than we do about our money now, and also inflation/interest rates on money. As you can see, using this payback period calculator you a percentage as an answer. Multiply this percentage by 365 and you will arrive at the number of days it will take for the project or investment to earn enough cash to pay for itself. For example, it may take time for a product manager‘s product or service to mature and get traction among a larger audience through good word of mouth.

How do you calculate payback period?

In simple terms, the payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash flow is positive, which is the payback year. Payback period is generally expressed in years.

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What is the example of the Payback Period?

All investors, investment managers, and business organizations have limited resources. Therefore, the need to make sound business decisions while selecting between a pool of investments is required. The main purpose of using the payback period is to enable managers, investors as well as organizations to make quick and sound decisions by selecting the most liquid project. A good CAC payback period in a SaaS company occurs in 12 months or less, with some companies aiming as low as 5-7 months. Companies with higher retention rates can generally afford longer CAC payback periods, but the right benchmark generally depends on the industry you’re in and your unique go-to-market strategy.

  • Below is a business case in which you will play the role of the chief managerial accountant advising the CEO and the board of directors about a key strategic investment opportunity.
  • In addition, some types of projects can take longer to complete than others.
  • Secondly, it is crucial to remember that a product or service needs enough time to grow and reach a wide range of audiences.
  • The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
  • This issue is addressed by using DPP, which uses discounted cash flows.
  • While calculating the payback period, we ignore the basic valuation of 2.5 lakh dollars over time.

There are other methods used in Capital budgeting such as Net Present Value, Internal Rate of Return and Discounted Cash Flow which are currently more in vogue. Note that year 3 is the year prior to fully recovering all the investment costs. This is because year 4 has a cumulative cashflow that exceed the initial investment. Hence, the number of years before fully recovering the investment cost is 3. In brief, PB calculated this way is an interpolated estimate between two of the period end-points (between the end of Year 3 and the end of Year 4).

Calculating the Payback Period

The shorter the payback period, the more attractive the investment would be, because this means it would take less time to break even. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment.

  • The cost of acquisition has already been sunk and so will remain the same, but the revenue side of the equation will be reduced.
  • Perhaps you’re torn between two investments and want to know which one can be recouped faster?
  • 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.
  • PBP is defined by calculating the time needed (usually expressed in years) to recover an investment.
  • Promoting technical support, training or paid-for research represent other new revenue streams.

The PBP is the time that elapses from the start of the project A, to the breakeven point E, where the rising part of the curve passes the zero cash position line. The PBP thus measures the time required for the cumulative project investment and other expenditure to be balanced by the cumulative income. The PBP is the time that elapses from the start of the project, A, to the break-even point, E, where the rising part of the curve passes the zero cash position line.

What is considered to be a good payback period?

CAC payback serves as a critical sales pipeline metric for SaaS companies. CAC payback builds the foundation for forecasting the breakeven point on cost of acquisition and provides insight into how efficiently your company monetizes customers. Other than running out of cash, the second biggest fear for CFOs is misrepresenting numbers in an important meeting with board investors or potential investors. And misrepresented numbers begin with finance calculating important metrics that tell a company’s growth narrative. The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back. Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number.

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