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5. Payback Period
The payback period is a useful calculation when deciding between two projects with the same rate of return
Payback Period (00:06)
The payback period for an investment is the length of time it takes you to get your initial investment back. It’s most useful when you’re making a decision between two investments with similar IRR or NPV.
To calculate the payback period, we create an IF statement for each year of the investment. This will check if the cumulative cash flows have reached or exceeded the initial investment. The payback period is the first year at which the initial investment is paid back.
Evaluating the Payback Period (02:23)
Given a choice, it’s best to select a project with a low payback period. The payback period is particularly important when evaluating risky projects, where the future returns may be quite uncertain.
There are a few issues with the payback period. Firstly, it only focuses on getting the initial investment back, and ignores any cash flows that come after this period. Secondly, it doesn’t discount future cash flows to account for the time value of money. For these reasons, you shouldn’t use the payback period as the primary method of evaluating an investment, but instead should use it as a secondary metric to IRR or NPV.