Calculate the payback period of capital investments

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The investment project involves the investment of significant amounts of financial resources. The initial task of investors is to determine the most attractive object for cash injections. Undoubtedly, it will be an enterprise that has a minimum payback period. But this practice is not always appropriate in commercial real estate. Also consider:

• net and discounted income;

• internal rate of return;

• profitability index.

The essence of calculating the payback period

To assess the risks of investing, the payback period of investments is calculated. This evaluation indicator is the period of time for which the invested funds will fully return and begin to make a profit. Three types of project payback are calculated:

• simple - from the first step to the return of all investments;

• for the operation period - does not include the investment phase;• discounted payback period - achievement the moment of return of the invested money, taking into account the ratediscounting.

The first and second are used if the parts of the advanced capital are evenly distributed in time. These methods consider the payback period as the ratio of initial costs to the average annual income, that is, to find the payback period of the project, it is necessary to divide the initial investment by the average annual amount of income from the project.

The simple calculation method does not take into account cash flows beyond the payback period, but allows you to draw conclusions about the liquidity and degree of risk of the project.

DiscountingIf income is uneven, then the payback period is calculated taking into account the different cost of money over time. This method calculates the amount of time required to return the advanced capital at the planned rate of return. Discounting is the calculation of the present value of money that will be received in the future.

To obtain reliable results, it is necessary to have information about the planned income, expenses, investments, the cost of liabilities and the discount rate. The latter is determined in several ways:

• based on the weighted average cost of capital;

• based on the safe investment rate (adjusted for various risk factors and without it);

• based on the effective rate interest on loan capital;

• adjusted for risk and cost of debt;

• based on the rate of return (intrinsic);

• expert evaluation method.

Discount periodpayback is calculated according to a formula in which the discount factor, the number of periods, the amount of initial investments, as well as the average annual amount of income from the project implementation "take part"

The obtained value allows you to evaluate the efficiency of capital investment and the level of investment risks. The payback period criterion allows you to cut off the most dubious and risky proposals at the initial stage. In further consideration of investment objects, it is recommended to use it in combination with other methods for determining attractiveness.