Payback period: formula. Investment and profit

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

The payback formula for a project is one of the important indicators in its evaluation. The payback period for investors is fundamental. It generally characterizes how liquid and profitable the project is. To correctly determine the optimality of investments, it is important to understand how the indicator is obtained and calculated.

Meaning of calculation

One of the most important indicators in determining the effectiveness of investments is the payback period. Its formula shows for what period of time the income from the project will cover all one-time costs for it. The method makes it possible to calculate the time for the return of funds, which the investor then correlates with his economically profitable and acceptable period.

Economic analysis involves the use of various methods in the calculation of the mentioned indicators. It is used if a comparative analysis is carried out to determine the most profitable project. It is important at the same time that it is not used as the main and only parameter, but is calculated andis analyzed in conjunction with the rest, showing the effectiveness of one or another investment option.

Calculation of the payback period as the main indicator can be used if the company is aimed at a quick return on investment. For example, when choosing ways to improve the company.

All other things being equal, the project with the shortest return period is accepted for implementation.

Return on investment is a formula that shows the number of periods (years or months) for which the investor will return his investment in full. In other words, this is the refund period. At the same time, it should be remembered that the named period should be shorter than the period of time during which the use of external loans is carried out.

What is needed for the calculation

The payback period (the formula for its use) requires knowledge of the following indicators:

• project costs - this includes all investments made since its inception;
• net income per year is the revenue from the implementation of the project received for the year, but minus all costs, including taxes;
• depreciation for the period (year) - the amount of money that was spent on improving the project and methods of its implementation (modernization and repair of equipment, improvement of technology, etc.);
• duration of costs (meaning investment).

And to calculate the discounted return on investment, it is important to take into account:

• receipt of all funds made fortime period under consideration;
• discount rate;
• period for which to discount;
• initial investment amount.

Payback formula

Determination of the period of return of investments takes into account the nature of the receipt of net income from the project. If it is assumed that cash flows are received evenly throughout the life of the project, the payback period, the formula of which is presented below, can be calculated as follows:

T=I/D

Where T is the return on investment;

And - attachments;

Y is the total profit.

In this case, the total amount of income consists of net profit and depreciation.

To understand how expedient the project under consideration is when using this methodology, it will help that the resulting value of the return on investment should be lower than that which was set by the investor.

In the real conditions of the project, the investor refuses it if the return period of investments is higher than the limit value set by him. Or he is looking for methods to reduce the payback period.

For example, an investor invests 100 thousand rubles in a project. Project income:

• in the first month amounted to 25 thousand rubles;
• in the second month - 35 thousand rubles;
• in the third month - 45 thousand rubles.

In the first two months, the project did not pay off, since 25+35=60 thousand rubles, which is lower than the amount of investments. Thus, it can be understood that the project paid off in three months, since 60 + 45=RUB 105,000

Method advantages

The advantages of the method described above are:

1. Easy calculation.
2. Visibility.
3. Possibility to classify investments according to the value set by the investor.

In general, this indicator can also be used to calculate the investment risk, since there is an inverse relationship: if the payback period, the formula of which is indicated above, decreases, the risks of the project also decrease. And vice versa, with an increase in the waiting period for a return on investment, the risk also increases - investments may become irrecoverable.

Disadvantages of the method

If we talk about the shortcomings of the method, then among them are: the inaccuracy of the calculation, due to the fact that the calculation does not take into account the time factor.

In fact, the proceeds that will be received outside the return period does not affect its period in any way.

In order to correctly calculate the indicator, it is important to understand by investments the costs of formation, reconstruction, improvement of fixed assets of the enterprise. As a result, the effect of them cannot come immediately.

An investor, when investing money in the improvement of any direction, must understand the fact that only after some time he will receive a non-negative value of the cash flow of capital. Because of this, it is important to use dynamic methods in calculations that discount flows, bringing the price of money to one point in time.

The need for such complex calculations is due to the fact that the price of money at the start date of the investment does not match the value of money at the end of the project.

Discounted calculation method

The payback period, the formula of which is presented below, involves taking into account the time factor. This is the calculation of NPV - net present value. The calculation is carried out according to the formula:

T=IC / FV, where T is the refund period;

IC – investment in the project;

FV – planned income for the project.

Here, the value of future money is taken into account, and therefore the planned income is discounted using the discount rate. This rate includes project risks. Among them, the main ones can be distinguished:

• risks of inflation;
• country risks;
• Risks of non-profit.

All of them are defined as percentages and summed up. The discount rate is determined as follows: risk-free rate of return + all project risks.

If the flow of money is not the same

If the income from the project is different every year, the cost recovery formula discussed in this article is determined in several steps.

1. First, you need to determine the number of periods (moreover, it must be an integer), when the amount of profit on a cumulative total becomes close to the amount of investments.
2. Then you need to determine the balance: subtract the amount of the accumulated amount of income from the project from the amount of investments.
3. After that, the valueuncovered balance is divided by the amount of cash inflows of the next period of time. The main economic indicator in this case is the discount rate, which is determined in fractions of a unit or as a percentage per year.

Conclusions

The payback period, the formula of which was discussed above, shows for what period of time there will be a full return on investment and the moment will come when the project will start to generate income. The investment option with the shortest return period is selected.

Several methods are used for the calculation, which have their own characteristics. The simplest is to divide the amount of costs by the amount of annual revenue that the funded project brings.