Management may want to know how long it will take until they get their invested funds back. Though this is a decidedly unscientific way to review cash flows, the author has yet to find a management team that did not insist on seeing a payback calculation alongside other, more sophisticated analysis methods.
There are two ways to calculate the payback period. The first method is the easiest to use, but can yield a skewed result. That calculation is to divide the capital investment by the average annual cash flow from operations. For example, in the following table we have a stream of cash flows over five years that is heavily weighted toward the time periods that are furthest in the future. The sum of those cash flows is $8,750,000, which is an average of $1,750,000 per year. We will also assume that the initial capital investment was $6,000,000. Based on this information, the payback period is $6,000,000 divided by $1,750,000, which is 3.4 years. However, if we review the stream of cash flows in the table, it is evident that the cash inflow did not cover the investment at the 3.4 year mark. In fact, the actual cash inflow did not exceed $6,000,000 until shortly after the end of the fourth year. What happened? The stream of cash flows in the example was so skewed toward future periods that the annual average cash flow was not representative of the annual actual cash flow. Thus, we can only use the averaging method if the stream of future cash flows is relatively even from year to year.
Year |
Cash Flow |
1 |
$1,000,000 |
2 |
1,250,000 |
3 |
1,500,000 |
4 |
2,000,000 |
5 |
3,000,000 |
The most accurate way to calculate the payback period is to do so manually. This means that we deduct the total expected cash inflow from the invested balance, year to by year, until we arrive at the correct period. For example, we have re-created the stream of cash flows in the following table, but now with an extra column that shows the net capital investment remaining at the end of each year. We can use this format to reach the end of year four; we know that the cash flows will pay back the investment sometime during year five, but we do not have a month-by-month cash flow that tells us precisely when. Instead, we can assume an average stream of cash flows during that period, which works out to $250,000 per month ($3,000,000 cash inflow for the year, divided by twelve months). Since there was only $250,000 of net investment remaining at the end of the fourth year, and this is the same monthly amount of cash flow in the fifth year, we can assume that the payback period is 4.1 years.
Year |
Cash Flow |
Net Investment Remaining |
0 |
0 |
$6,000,000 |
1 |
$1,000,000 |
5,000,000 |
2 |
1,250,000 |
3,750,000 |
3 |
1,500,000 |
2,250,000 |
4 |
2,000,000 |
250,000 |
5 |
3,000,000 |
--- |
The payback period is not a highly scientific method, because it completely ignores the time value of money. Nonetheless, it tells management how much time will pass before it recovers its invested funds, which can be useful information, especially in such environments as high technology, where investments must attain a nearly immediate payback before they become obsolete. Accordingly, it is customary to include the payback calculation in a capital investment analysis, though it must be strongly supplemented by a discounted cash flow analysis.