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How do you calculate the payback period?

Author:
Harold Averkamp, CPA, MBA

Definition of Payback Period

The payback period is the expected number of years it will take for a company to recoup the cash it invested in a project.

Examples of Payback Periods

Let’s assume that a company invests cash of $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is expected to be 4 years ($400,000 divided by $100,000 per year).

A second project requires a cash investment of $200,000 and it generates cash as follows:

  • Year 1: $20,000
  • Year 2: $60,000
  • Year 3: $80,000
  • Year 4: $100,000
  • Year 5: $70,000

The payback period is 3.4 years ($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000 occurring in Year 4).

Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project’s total profitability over its entire life, nor are the cash flows discounted for the time value of money.

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About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

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