Accounting



How do you calculate the payback period?

The payback period is calculated by counting the number of years it will take to recover the cash invested in a project.

Let’s assume that a company invests $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 4 years ($400,000 divided by $100,000 per year).

A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. 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. Rather, the payback period simply computes how fast a company will recover its cash investment.

Learn more about Evaluating Business Investments.

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About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.




Comments

5 Responses to “How do you calculate the payback period?”

  1. Mahmoud on March 1st, 2010 3:40 am

    What Mean IRR ?
    &
    How can Calculate IRR ?

  2. arbab samiullah kasi on March 7th, 2010 3:27 pm

    The payback period is calculated by counting the number of years it will take to recover the cash invested in a project.

  3. Alick on March 9th, 2010 7:18 am

    I salute sir Averkamp for his extraordinary and remarkable experience in accounting . you are my yard stick for furthering my carreer in accounting

  4. Qasim Ranta on May 12th, 2010 11:14 pm

    IRR = internal rate of return
    formula of IRR is FV = PV(1+j)^n
    formula of IRR is PV = FV/(1+j)^n

    FV = future value
    PV = Present value
    Percentage of rate i.e. (if 25% then 0.25)
    n = number of year

  5. siva on May 27th, 2010 8:57 pm

    IRR means internal rate of return in this method over all cost of capital Equal to ROE it is acceptabe for the project, 1-ROE is equl to ke 2-ROE Is geater than the ke (ke means over all weighted average cost )

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