4 ways to calculate payback time accurately

Payback period is an important indicator that helps businesses and investors determine the time needed to recover the initial investment. Understanding the payback period calculation methods not only helps evaluate financial performance but also supports making accurate investment decisions. Let's coming Refer to 4 Optimize payback time and project performance with Viindoo Project exactly in this article

1. What is the payback period?

Payback Period is the time it takes for an investment to recover its initial capital through accumulated cash flow. Simply put, it is the moment when the revenue from the project is enough to cover the initial costs.  

The shorter the payback period, the more assured investors are about the ability to recover capital and see more clearly the benefits of the project. Calculation methods may or may not include the time value of money, depending on the approach used.

For example: You invest 100 million VND in a project. Each year the project brings a profit of 20 million VND. The payback period of this project will be 5 years (100 million VND: 20 million VND/year).

2. Four ways to calculate payback period

Calculating the payback period is an important step in evaluating investment efficiency. Here are four popular methods:

2.1 Method 1: How to calculate the undiscounted payback period with uniform cash flow

This method is applied when the annual cash flow from the project is stable. The calculation formula is as follows:

Payback period = Initial investment amount / Annual cash flow

This is the simplest method, used to determine the number of years needed for the cash flow to equal the exact amount of the initial investment, assuming that the cash flow each year is the same.. The advantage of this method is that it is easy to understand and calculate. However, the major drawback is that it does not consider the time value of money, that is, it does not evaluate the decrease in value of money received in later years compared to money received in the first year.

For example: You invest 1 billion VND in a project. Each year, the project brings you 200 million VND.  

So the time for you to recover your capital is: 

Payback period = 1.000.000.000 / 200.000.000 = 5 years

=> After 5 years, the total amount you receive will be equal to the amount you initially invested.

2.2 Method 2: How to calculate the undiscounted payback period with changing cash flows

When the annual cash flow is uneven, calculate the payback period by accumulating the cash flow until the total initial investment is reached. The formula is as follows

Payback period = Final year with total cumulative cash flow ≥ Initial investment

Unlike the method of calculating the undiscounted payback period with steady cash flows, this method is more suitable for projects with unstable cash flows over the years. It allows for more accurate calculation of payback periods as cash flows vary. This method is more flexible and reflects reality but still does not take into account the time value of money, that is, it does not discount cash flows to their present value.

Calculation:

1. Calculate net cash flow each year: Total income minus total annual expenses.
2. Calculate cumulative cash flow: Add up the annual net cash flow.
3. Determine the payback year: Find the year in which the cumulative cash flow equals or exceeds the initial investment. That year is the payback period.

For example:   Suppose you invest 1 billion VND in a project. Net cash flows for the years are as follows:

Year 1: 200 million

Year 2: 300 million

Year 3: 400 million

Year 4: 500 million

​Calculate:

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Year 1: Cumulative cash flow = 200 million

Year 2: Cumulative cash flow = 200 million + 300 million = 500 million

Year 3: Cumulative cash flow = 500 million + 400 million = 900 million

Year 4: Cumulative cash flow = 900 million + 500 million = 1,400 million

=> After 3 years, the total accumulated cash flow has exceeded 1 billion VND (initial investment capital). So the payback period of the project is 3 years.

2.3 Method 3: How to calculate the discounted payback period

The discounted payback period method is a method of determining the payback period for the entire initial investment, taking into account the present value of cash flows. To calculate the discounted payback period, two steps are required:

Step 1: Discount all expected future cash flows to their present value using the formula:

Present valuei = Expected cash flow / (1 + Interest rate)^Number of terms

Step 2: Apply the payback period calculation as the undiscounted method to cash flows discounted to present value.

Discounted payback period = Payback year + (Unrecovered cash flow in the payback year / Average annual net cash flow)

With:

• Payback year: The year in which the cumulative cash flow reaches or exceeds the initial investment capital
• Unrecovered cash flow in the payback year: The remaining amount needs to be recovered in the payback year
• Average annual net cash flow: Average annual net cash flow after discounting

The discounted cash flow method is considered the most accurate because it takes into account the time value of money, providing a realistic view of project value. The advantage of this method is that it accurately reflects the real value of the project, including inflation and risk factors. However, the disadvantage is that this method is more complicated, requiring the determination of an appropriate discount rate, increasing the difficulty in the calculation and analysis process.

Calculation:

1. Calculate net cash flow each year: Total income minus total annual expenses.
2. Calculate cumulative cash flow: Add up the annual net cash flow.
3. Determine the payback year: Find the year in which the cumulative cash flow equals or exceeds the initial investment. That year is the payback period.

For example:   Suppose a company invests 100 million VND in a project with the following expected net cash flow:

Year 1: 20 million VND

Year 2: 30 million VND

Year 3: 40 million VND

Year 4: 50 million VND

The discount rate is 10%.

Step 1: Discount the cash flow to its present value

1 year: 20 million / (1+0.10)^1 = 18.18 million VND

Year 2: 30 millions / (1+0.10)^2 = 24.79 million VND

Year 3: 40 million / (1+0.10)^3 = 30.05 million VND

Year 4: 50 millions / (1+0.10)^4 ​= 34.15 million VND

Step 2: Calculate the discounted payback period

The discounted payback period is the point at which the cumulative cash flow becomes positive. Since year 3, cumulative cash flow has been positive with an unrecovered value of VND 26.98 million. Average annual net cash flow (after discount) is 24.34 million VND.

Discounted payback period =

Discounted payback period = 3 + (26.98 million​ / 24.34 million) ≈ 3.11 years

-> The results show that this project will pay back in about 3.11 years when applying a 10% discount rate.

2.4 Method 4: How to calculate payback period by month

This method is suitable for projects with short payback periods, calculated in months. The formula is as follows:

Payback period (month) = Initial investment capital / Monthly cash flow

The monthly payback period calculation method allows for a more detailed assessment of the project's capital recovery progress, compared to the annual calculation method. The advantage of this method is that it provides more detailed information about capital recovery progress, helping to manage finances more effectively. However, the disadvantage is that this method is more complicated to calculate, especially for projects with monthly cash flow changes, requiring more careful management and monitoring.

For example: Suppose a company invests in a marketing campaign with an initial cost of 12 million VND. It is expected that each month the campaign will bring in a profit of 2 million VND.

Month 1: Cumulative cash flow = 2 million

February: Cumulative cash flow = 4 million

March: Cumulative cash flow = 6 million

...

June: Cumulative cash flow = 12 million

=> So the payback period of this campaign is 6 months.

3. Manage payback time with Viindoo Accounting & Finance

Currently, businesses can optimize the process of calculating and managing payback period with accounting software. Accounting software helps businesses collect and manage data on project cash inflows and outflows, including initial investment costs, annual revenue and operating costs. These are the basic data for calculating the payback period. One of the effective software capable of supporting the calculation of payback period that businesses can consider is Viindoo Accounting.

Viindoo Accounting with many powerful features will be an effective assistant for businesses in the process of project cost management in general and payback period management in particular. For example:

• Viindoo Accounting has the ability to control data throughout in real time, all transactions, from sales invoices, warehousing, payments to other accounting entries are recorded and updated immediately into the system. system. This helps businesses always grasp the current financial situation of the project.
• Viindoo Accounting integrates perfectly with other software such as Viindoo Project, Logistics, Expenditure, Sales,... to help collect data on costs, revenue, and operating costs accurately and completely. best. Thanks to that, businesses have complete and accurate data to calculate cash flow, profits,... and then calculate the payback period. 
• Smart filtering and search tools in Viindoo Accounting help quickly find accounting information based on multiple criteria

Own how to calculate payback period is a key factor in making smart investment decisions. Viindoo Project will be a reliable companion, helping businesses optimize this process and achieve outstanding business performance.