The payback period tells you how long it takes to recover the initial cost of an investment from the cash flows it generates. It is one of the simplest capital budgeting techniques and is widely used for quick project comparison.
The Basic Formula (Even Cash Flows)
When cash inflows are the same each year:
Payback period = Initial investment ÷ Annual cash inflow
Example: A machine costs £50,000 and generates £12,500 per year.
Payback period = 50,000 ÷ 12,500 = 4 years
Uneven Cash Flows
Most real projects have irregular cash flows. Use a cumulative approach:
| Year | Cash inflow | Cumulative |
|---|---|---|
| 0 | −£80,000 | −£80,000 |
| 1 | £20,000 | −£60,000 |
| 2 | £25,000 | −£35,000 |
| 3 | £30,000 | −£5,000 |
| 4 | £20,000 | +£15,000 |
The investment is recovered during Year 4. To find the exact month:
Exact payback = 3 + (5,000 ÷ 20,000) = 3.25 years = 3 years and 3 months
Discounted Payback Period
The simple payback period ignores the time value of money. The discounted payback period uses present values of cash flows instead.
Example: Discount rate 10%, same cash flows as above:
| Year | Cash flow | Discount factor | PV | Cumulative PV |
|---|---|---|---|---|
| 1 | £20,000 | 0.909 | £18,182 | −£61,818 |
| 2 | £25,000 | 0.826 | £20,661 | −£41,157 |
| 3 | £30,000 | 0.751 | £22,539 | −£18,618 |
| 4 | £20,000 | 0.683 | £13,660 | −£4,958 |
| 5 | £20,000 | 0.621 | £12,418 | +£7,460 |
Discounted payback ≈ 4.4 years (vs 3.25 years simple).
Decision Rule
- Companies often set a cutoff payback period (e.g. 3 years)
- Projects with shorter payback periods are preferred
- Projects exceeding the cutoff are rejected
Advantages and Limitations
Advantages:
- Simple to calculate and communicate
- Useful for liquidity-constrained businesses
- Good indicator of investment risk (shorter = less risky)
Limitations:
- Ignores cash flows after the payback period (misses long-term projects)
- Does not account for time value of money (unless discounted method used)
- Cannot distinguish between projects of different scale
When to Use Payback Period
Best suited for: small businesses, startups, or businesses with high capital constraints who need to recover cash quickly. Always complement with NPV or IRR for a complete picture.