It is important to investors to know the payback period of the investments they make. This can direct then to either put their money into a particular investment or go for another. The payback period is the number of periods it will take to pay back the initial investment on a capital. Another way of putting it is this; the payback period of an investment is how long it will take for that investment to get to its break even.
There are a number of things that can be gained from calculating the payback period of an investment. Some of them are
- Projecting the cash flows
- Interest payment
- Investment value management techniques
- Projecting project influence
Projecting the influence of the project on the entire corporation asset management and profitability is a really important benefit of this. The formula for calculating it is
Payback period = Initial investment / net annual cash flow
Initial investment is the amount of money that is cost to set up an investment from scratch. It also involves the cost of getting an investment financed like interest, tax, etc. it can also be referred to as the amount of money a person puts into an already existing business.
Net annual cash flow is the difference between a company’s cash inflows and out flows within a one year period. To run an investment efficiently, there is need to spend money on things that will help generate more income for the company, that is the outflow of cash. While money is being spent, better ways are being provided to ensure that the profitability of the company is attractive; cash inflow. The difference between the amount of money that comes into a company, and the amount that leaves, in a period of one year is the net annual cash flow.
To calculate the payback period of an investment, start with the initial investment value and go ahead to divide it with the average net cash flow value.
If a company spends $10,000 on a piece of capital asset that will generate an extra $1000 in EBIT, and has a lifespan of 20 years, what will be its payback period?
Payback period = 10,000 / 1000
= 10 years
This means that it will take a period of ten years to repay the investment capital that was use to purchase this asset.
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