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.