## Payback Period Explained, With the Formula and How to Calculate It

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However, Payback Period likely he would search out another machine to buy, one with a longer life, or shelf the idea altogether. Or the numbers suddenly start fluctuating downwards from year 3 on?

Annual percentage rates vary from 23% to about 78%, depending on amount borrowed and payback period. The GoCardless content team comprises a group of subject-matter experts in multiple fields from across GoCardless. The authors and reviewers work in the sales, marketing, legal, and finance departments. All have in-depth knowledge and experience in various aspects of payment scheme technology and the operating rules applicable to each. However, considering that not every project lasts the exact length of a year, you can use this equation for any period of income.

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A week has passed since Mike Haley, accountant, discussed this investment with Julie Jackson, president and owner. Evaluates how long it will take to recover the initial investment. Then, you have the last resort — if a customer opts to leave, try offering them an incentive to stay. For example, you can use a discounted rate or access to a higher tier to tempt customers into staying.

- There can be lots of strategies to use, so it can often be difficult to know where to start.
- 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.
- Payback period, which is used most often in capital budgeting, is the period of time required to reach the break-even point of an investment based on cash flow.
- Convertkit is a company that offers a yearly subscription that comes at a reduced cost.
- While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

Here’s a hypothetical example to show how the payback period works. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment.

## How to reduce payback period

Add payback period to one of your lists below, or create a new one. Building a new power station has a lead-up of three to five years just for implementation, and a payback period of 20 to 30 years. The typical payback period for photovoltaic installations is 50–100 years.

The https://www.bookstime.com/ period is the sales and marketing spend from Quarter 1 ($6,000) divided by the difference in revenue from Quarter 1 to Quarter 2 ($1,250). The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. As mentioned above, payback period calculation is used by management to find out how quickly they can get the firm’s money back from an investment. As expected, the investment is riskier if it takes too long for an investment to repay its initial price.

## What Are the Advantages of Calculating the Payback Period?

Some are less so – for example press coverage, hackathon events and how you support your current customers all feed into your brand reputation. In theory, payback period should include all customer acquisition costs, not just the direct ones. But attributing an activity to a customer acquisition is easier said than done. An implicit variable is thetype of acquired customer that you are considering in your calculation. While you can calculate an average of the payback period for all of your customers, you’ll end up with a number somewhere between the shortest and longest payback periods . This gives you a general snapshot of your acquisition strategy but doesn’t provide direction for improvement.

This is important because money today is worth more than money in the future. The discount rate represents the opportunity cost of investing your money.

## Advantages and disadvantages of payback period

WACC can be used in place of discount rate for either of the calculations. The payback period is a financial metric used to determine how long it will take for a company to recoup its initial investment in a project. The payback period is calculated by dividing the total cost of the project by the company’s projected annual cash flow from the project.

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At the point in time when the cumulative present value of the benefits starts to exceed the cumulative present value of the costs, the project has reached the payback period. Ranking projects then becomes a matter of selecting those projects with the shortest payback period. In an Energy Conservation Option usually the annual money saving is only due to energy savings and hence it is the product of the energy saved and the price of energy. But in the case of unequal cash inflows the PB period can be found out by adding up the cash inflows until the total is equal to initial cash outlay. This is the simplest and easiest way to understand but it does not give us the real picture as it does not consider ther time value of money or the cash flows occurring after PB period. There is no clear-cut rule regarding a minimum SPP to accept the project. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation.