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When you invest money, you want to make more money from your investment. Ideally, you would make a huge amount, and the worst-case scenario would be causing a loss. At the very least, an investor should be able to recover the initial investment. The time taken to recover this initial investment is called the payback period. A short payback period is desirable for an investor looking to invest with low risk. It is one of the metrics used to evaluate the return on investment and suitability of a project or investment by investors.
The time it takes to recover an investment is the payback period, and it can also be described as the time it takes to break even and have the initial amount you invested back in your hand. The money that you make after this payback period will be a profit.
The payback period is an essential factor when choosing between different investment options. Some projects have relatively short payback periods while others have longer ones. The payback period affects the risk that is involved in the investment. When you budget your capital, you must consider how many years it takes for the project to pay for itself. So, if it would take 7 years for you to make the money that you put into the project or investment, the payback period is 7 years. The payback period is an important part of the return on investment calculation that also includes other metrics. However, the payback period calculation merely estimates the time taken to recover the initial amount and does not include the time value of money.
Let us take the example of a company investing in new equipment that will cost them 40,000 Taka. This equipment will enable them to ramp up production and generate 20,000 Taka additional cash flow annually. This would mean that the payback period for this investment is 2 years. The company also estimates for additional machinery that will cost 30,000 Taka and save 6,000 Taka annually, and the payback period is 5 years. If the company only has cash for one of these projects and were to choose based on the payback period, the investment with the shorter payback period would be the better choice.
The ideal payback period differs across industries and projects, and the payback period is an excellent metric to use when comparing projects. When all other factors are similar, a company or individual can use the payback period to choose one over the other.
The payback period is not the same as the break-even point. The payback period is the time period (usually in years) that it will take for the investor to recover the initial investment. So, it is a measure across potentially many future accounting periods over which the investment can be recovered and not on a single income statement. The payback period calculation is usually used to make decisions on capital expenditures. It does not include the time value of money or any calculation relating to the cash flow after the payback period.
The breakeven point is the amount of money a company must make to cover its expenses and costs. So, in accrual accounting, when a company reaches break-even, the income statement will show a balance of 0. It is calculated by dividing fixed expenses by the contribution margin ratio for the period.
So, while the breakeven point is the amount of money the company has to make, the payback period measures the time that will be taken to recover an investment.
The formula to calculate the payback period is :
Payback Period = Initial Investment Cost / Cash Inflow For That Period
So, if an investment of 20,000 Taka is made and will give returns of 10,000 Taka per year, the payback period is calculated as:
payback period = 20,000 / 10,000 = 2 years
The payback period is a quick and easy method of calculating one of the factors of return on investment, but it does have its disadvantages as follows:
Companies usually spend readily when they have liquidity. However, a liquidity crunch would mean the company would have to make capital investment decisions wisely. Liquidity issues would necessitate that the company prefers the investment that would give quicker returns on the investment. So, an investment with a shorter payback period would be preferable.
A payback calculator is a useful tool for decision-making. A software tool for calculating the payback period will help you choose between different project options and their return periods.
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