How the payback period works
The payback period is how long a project takes to hand back the cash it cost. A $60,000 machine returning $18,000 a year pays for itself in 3.33 years. Payback stops counting there, and it treats a dollar in year 4 as a dollar today, so it screens projects rather than choosing between them.
Payback period
3.33 years
The $60,000.00 cost is back in hand by the end of year 4, when $72,000.00 has come in. What the project does after that is invisible to this measure.
- Cash that clears the cost
- $60,000.00
- Cash arriving after payback
- $30,000.00
- Total cash over 5 years
- $90,000.00
The count stops at payback, so the later years never reach the headline.
On this page
In short
- A $60,000 machine returning $18,000 a year pays back in 3.33 years. Year 4 is the year the remaining outlay is recovered, 0.3333 of the way through that year's $18,000.
- By the end of year 4 the project has collected $72,000 against the $60,000 it cost. Payback has already stopped counting. What is left after the payback date is the part a project is bought for.
- Discount each $18,000 at 10 percent and the same machine's discounted payback is 4.26 years. The five discounted receipts add to $68,234.16. Waiting is no longer free.
- Two projects can each cost $60,000, each return $25,000 a year, and each pay back in 2.4 years. One then stops. The other runs three more years. Payback scores them the same.
- Payback is a screen for how long cash is tied up. NPV is the ranking tool, because it keeps counting after the outlay is recovered.
A clock that stops when the outlay is back
Payback adds up a project's cash flow until the running total matches what was spent at the start. When every year pays the same, that is outlay over the annual receipt.
A $60,000 machine returning $18,000 a year: after one year $18,000, after two years another $18,000, after three years a third. Year 4 opens still short of $60,000. That year brings $18,000, so the shortfall clears 0.3333 of the way through it. Payback is 3.33 years, 3 years and 4 months.
By the end of year 4 the project has collected $72,000. Payback does not mention that, or year 5. It stopped at 3.33 years. The payback period calculator on this page is that count.
How NPV and IRR work is the page that keeps going after the outlay is recovered. How break-even analysis works is a volume, not a date.
Plain payback treats waiting as free
Charge 10 percent a year for the wait, then ask the same question of the same $60,000 and five $18,000 receipts. The discounted cash flows are $16,363.64, $14,876.03, $13,523.67, $12,294.24 and $11,176.58. The running total is still short of $60,000 after year 4. Discounted payback is 4.26 years.
All five years are worth $68,234.16 in today's money against the $60,000 cost, so the project still clears, but most of its life now goes on simply getting the money back. Plain payback's 3.33 years had treated a dollar in year 4 as a dollar today.
Plain payback and discounted payback are the same clock asked with and without a cost of waiting. Discounted against plain payback is the two scores on one sheet, including the case where they rank two projects the same and the cash after payback is not the same at all.
The same score, twice the cash
Two projects each cost $60,000 and each return $25,000 a year. Both are still short after two years of $25,000, both clear 0.4 of the way through year 3, so both pay back in 2.4 years. By the end of year 3 each has taken in $75,000.
One then stops. The other runs through years 4, 5 and 6 and collects another $75,000 that payback never sees. Same score. Different projects. Rank them by payback and you have not ranked them by value.
What this page is not doing
It is not NPV, not IRR, and not a claim that 3.33 years is a good cutoff. The three sheets are $18,000 a year on a $60,000 machine (3.33 years, $72,000 collected by the end of year 4), the same receipts discounted at 10 percent (4.26 years, $68,234.16), and $25,000 a year for six years (2.4 years, $75,000 by the end of year 3). This is educational material, not financial advice.
Worked examples
A \$60,000 machine returning \$18,000 a year
A machine costs $60,000 up front and is expected to bring in $18,000 of net cash a year for five years. How long before it has paid for itself?
- Run the cash total forward: after year 1, after year 2, after year 3. The cost is not covered yet.
- Year 4 opens with still to recover.
- That year brings in $18,000, so the shortfall clears of the way through it.
- Payback is years, which is 3 years and 4 months.
The machine pays for itself in 3.33 years. Payback lands a third of the way into year 4, by the end of which the project has collected $72,000 against the $60,000 it cost. What is left after the payback date is a further year and eight months of cash, and that is the part a project is bought for. The payback figure says nothing about it.
The same machine with the waiting priced in
Plain payback counts a dollar in year 4 as equal to a dollar today. Charge 10 percent a year for the waiting first, then ask the same question of the same $60,000 machine.
- Discount each year's $18,000 back to today: , , , , .
- Run the total on those figures: , then , then , then by the end of year 4, still short of .
- Year 5 opens with left to recover, against $11,176.58 arriving that year.
- of the year, so payback is years.
Discounted payback is 4.26 years against 3.33 years for the same machine, nearly a year later, and not one of the project's cash flows changed. All five years are worth $68,234.16 in today's money against the $60,000 the machine cost, so the project still clears its outlay, but most of its life now goes on simply getting the money back. Plain payback treats waiting as free, and over a long project that is a large thing to treat as free.
Two projects, the same payback, very different value
Two projects each cost $60,000 and each return $25,000 of cash a year. Project A wears out at the end of year 3. Project B runs for six years. Payback scores them identically. Should you?
- Both collect in year 1 and by the end of year 2, so both are still short.
- Both clear that in year 3: of the year, so payback is years for each.
- By the end of year 3 each has taken in $75,000, and that is where Project A stops.
- Project B collects another $75,000 across years 4, 5 and 6. The payback count ended at 2.4 years, so none of it registers.
Both pay back in 2.4 years, and by the end of year 3 both have collected $75,000 against the $60,000 they cost. Project B then earns a further $75,000 that Project A never sees. Same score, and B collects twice the cash. Take the $60,000 cost off each and B's gain is six times A's, not twice it. Price the waiting in as well and the gap is wider still. Payback is not measuring value, so it cannot rank by value.
Common questions
What is a good payback period?
There is no market rate for it. A business sets its own cutoff from how long it can stand to have cash tied up and how confident it is about the later years. On this sheet the $60,000 machine prints 3.33 years. That is a description of those cash flows, not a grade.
Should payback use cash flow or profit?
Cash flow. Depreciation reduces reported profit without money leaving the bank, so a payback from profit shows a longer wait than the real one. The $18,000 on this sheet is net cash, not an accounting profit line.
Is discounted payback enough to rank projects?
It is better than plain payback in one way: it charges for waiting, which is why the same machine moves from 3.33 years to 4.26. It still stops counting once the outlay is back, so a long tail of cash after that date still does not show. NPV keeps counting.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.