9. Payback Period

 
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Overview

The payback period is a useful calculation when deciding between two projects with the same rate of return

Lesson Notes

Payback period

- Calculates how many years it will take to recover initial investment
- Can be used to choose between projects with similar rates of return
- Should not be used as the primary valuation method for investments

Calculating the payback period

- For each year, calculate cumulative cashflows since the beginning of the project
- The first year the cumulative cashflows are greater than the initial investment = payback period

Why payback period should not be used as primary valuation method

- Payback period does not take into account the time value of money
- Payback period ignores the value of all cashflows after the payback period

Keyboard shortcuts

SHIFT + : Select next cell
CTRL + SHIFT + : Select all cells within data region
F2: Jump back inside a formula
F4: Anchor cells

Transcript

The payback period calculation does exactly what you think it does.

It calculates how long it will take to get your original investment back.

It should not be used as the primary method of valuating investments, but it’s a good way to differentiate between two investments that have a similar IRR or NPV.

Let's take the example of two competing projects.

I'm going to calculate the IRR for these projects quickly.

So for the first project, I'll write “=IRR” and select my cash flows.

And this gives me a value of 16.5%.

If I do it for the second project, you'll see that we have the exact same IRR.

So how do we pick a winner between these two investments? Let's start by calculating our payback period.

To calculate the payback period, I'll simply check if the cumulative cash flows each year have reached $20,000.

And if they have, I'll write yes, and if they haven't, I'll write no.

So starting in the last cell, I'll write “=if”, and the logical test will be if the sum of the cash flows plus the original investment is greater than or equal to zero.

And if it is, I'll write yes, and if it isn't, I'll write no.

Then I'll close the bracket and press Enter.

And this tells me that by year six for project one, that the money has been paid back.

I'll now need to repeat this formula for the remaining cells, but to do this, I'll first need to perform some anchoring.

So I'll press F2 to jump back into the formula, and then anchor C4 so that the dollar sign is just in front of the letter.

And I'll do the same for D4.

And then I'll copy and paste for the remaining cells.

And when I press Enter, you can see that for project one our payback period is reached in year three, but for project two our payback period has been reached in year five.

When looking at project cash flows, it’s easy to forget the uncertainty surrounding cash flows that are four and five years into the future.

But from my perspective, I would almost always choose the option with the lower payback period.

For riskier projects with a high discount rate, or for a project where you are borrowing money to invest, the payback period becomes even more important.

Although the payback period can help us decide between two projects with a similar IRR or NPV, it should not be used as the primary method of valuation, for two obvious reasons.

First, it ignores any cash flows after the cutoff date.

And second, it doesn't apply the time value of money principle to any cash flow.

So if the payback period on a project was six years, there’s no differentiation between cash flows in year four and cash flows in year one.

The simplicity of the payback makes it an easy device for loosely describing investment projects, however the payback period should always be used secondary to IRR or NPV when making investment decisions.

One question you might be asking yourself at this point, is if IRR and NPV always give the same investment recommendations.

We'll answer this question in the next lesson.