The payback period denotes the number of years or periods a project will take to recover the initial investment for the project. It is determined in terms of years or periods.
To calculate the payback period the net cash flow is calculated after considering the cash inflow at the end of each period until it reaches zero. When the net cash flow reaches zero, which will be the payback period. It does not consider the discounted cash flow.
Example of payback period calculation
Suppose for project X, the initial investment or cash outflow is 1000 USD. So net cash flow at the beginning is -1000 USD.
The project will generate cash inflows for next 5 years. The cash inflows for project X are 400 USD, 350 USD, 300 USD, 250 USD and 200 USD respectively. Total Cash inflow will be 1500 USD over the next 5 years.
After first year the net cash flow will be (-1000 + 400) = -600 USD.
After second year the net cash flow will be (-600 + 350) = -250 USD
After third year the net cash flow will be (-250 + 250) = 0 USD. So after third year, the net cash flow will be zero. It makes the payback period for the project X as 3 years.
If the net cash flow stays greater than zero and less than the next year’s cash inflow, then fraction will be used to calculate the appropriate payback period.
As it does not use the discounted method and consider the cash flows after the payback period, it cannot guarantee a correct capital budgeting evaluation process. But it can be used for companies with liquidity constraints as lower payback period ensures more liquidity.