Learn here what Payback is, how it works and the best way to calculate it!

Do you know what Payback is? This is a concept widely used in the investment world, and let's learn a little more about it in this article!

Have you ever wondered how investors find out how long they will get a return on investment? After all, no money is applied to something without knowing how long the results will appear, right? And that's exactly why the payback period is used. Let’s learn how to calculate Payback Period?

This concept is very used in economic engineering and allows easy and simple visualization of the investment made. Like any method, it has advantages and disadvantages in its application, and that is exactly what we are going to talk about in this article.

In order for you to stay even more on top of all the news about the world of investments, learn how to differentiate simple payback from discounted payback, and also how to calculate each of them easily we have separated in this article several topics full of information! Check it out!

• What is Payback?
• Advantages and disadvantages of Payback
• Main differences between Simple Payback and Discounted Payback
• How to calculate Simple Payback
• How to calculate Discounted Payback
• Don't stop here!

What is the Payback?

The Payback period is a term used within the financial management to indicate the time elapsed from the time of initial investment to the time when the net profit equals the amount invested.

The calculation of the payback period of an investment is quite simple, and gives the manager a quick view of the project, allowing a decision on whether to move forward or not, based on the verified risk.

Payback Period time does not follow a pre-established pattern, as it depends on factors such as the value of the initial investment and type of business. It can range from a few months to years, after all, a very high investment will probably require a longer time to be returned.

Payback is linked to some other indicators, which are:

• NPV (Net Present Value): is the accumulated value of all the cash flow brought to the present value. It serves to analyze whether an investment is feasible or not, and also for the exact calculation of the payback.
• ROI (Return on Investment): Evaluates the return on own and third-party investments in the company
• Internal Rate of Return (IRR): a discount rate that must have a cash flow so that its NPV is zero

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Advantages and disadvantages of Payback

Just like every mathematical method, there are good points and bad points of using Payback Period to analyze the feasibility of an investment. And what are they?

Advantages of Payback

• Easy to calculate and be learned.
• Provides an idea of the level of project liquidity and risk
• It increases the level of security of investments made by a company in times of financial market instability, due to the advantage presented above.
• Extremely useful when the project risk is very high or when the project has a limited life.

Payback Disadvantages

• Do not consider cash flow after the year of recovery, ie, long projects are not very recommended.
• It does not present a very clear analysis.

Main Difference between Simple Payback and Discounted Payback

As you read at the beginning of this article, there are two types of payback period: payback period and discounted payback period.

The Payback Period is calculated directly. It is the number of months or years required to recover an investment made.

It does not consider the value of money over time and is also limited to the time when profit covers the investment.

Because of this, some mathematical experts consider this method to be incorrect because it does not respect the principles of equivalence between rates, a concept derived from financial mathematics.

Discounted payback period exists precisely to fill the gaps that occur in the calculation of the payback period. But how?

It uses a discount rate that can be annual or monthly, according to investor interest. Generally, the rate used is the Hurdle Rate, that is, the minimum rate of attractiveness.

This rate can be stipulated by the company itself, which determines how many percents it wants to gain on a given investment.

In the discounted payback period all portions of the cash flow will have the discount of that determined rate in relation to a specified period.

Now that you have understood the theoretical concept, it is time to apply it in practice. Let&rsquos go?

How to Calculate the Payback Period?

Let's begin with the easiest method, and then make it difficult. To calculate the payback period, use the following formula:

When you know the initial investment, we just calculate the gain obtained with the investment to find out the value of our cash flow, and then we find out the period needed to cover the amount invested.

To better understand, let's take a look at the following example:

"An automaker wants to reduce costs in the manufacture of "steel boobs", a part installed under the engine to protect it from impacts. The engineering department found a press that can reduce the cost of production by 12% with an investment of R$ 1.7 million. Knowing that each piece has a cost of R$123.00, that 21,000 pieces are produced in the month, and that the company wants to return in 3 months, decide whether the project should be accepted or not "

It is clear from the reading that the investment to be made is 1,7 million to acquire the press. Considering this you already have the numerator of your formula, and to find the denominator, we just need to make a simple account.

If the press will reduce the cost of manufacturing by 12%, we can subtract this percentage from the current cost to manufacture a part, which is $ 123.00. So, it is found that the new cost per piece will be R$ 108.24.

To find the profit obtained per piece, simply subtract these two values. So, we find that by purchasing the press, R$ 14.76 per piece will be saved. To find out your cash flow, simply multiply this amount by the number of pieces produced per month.

After all, we arrive at the following calculation:

Therefore, 5.48 months is the necessary time for the investment made to obtain a return. As the company wanted to get a return in 3 months, in this case, the project will be refused because it did not meet this requirement.

How to calculate discounted Payback?

Using the same example above we can demonstrate how to calculate the discounted payback period.

As seen in the theoretical part, the difference from one to another is the fact that the discounted payback period takes into consideration a discount rate defined by the investors.

We will then consider the hurdle rate to be set at 10% for this investment. So, just do the following calculation to find out the value of the discounted payback period:

In this way you take into consideration the monthly discount rate established. Therefore, it is clear that by using discounted payback period, the investment takes even longer to achieve the desired return, making it even more unfeasible.

Did you understand what Payback Period is and how to calculate it?

As you can see, calculating the payback period and the discounted payback period is not hard to do. Just find out your cash flow, that is, how much that investment will give you return per month and apply on the type of payback period you want to calculate.

Quickly you will be able to visualize the investment risk as well as analyze if it will bring the desired return within the established time frame.

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