Calculating payback period – a helpful tool to assess projects
Unsure if a new project is worthwhile investment of your time, effort and money? One way to figure this out is to assess the project based on the payback period - the time it will take to recover the capital outflow of a project.
Calculating payback period
Example #1: A dairy producer wants to capture a new revenue stream, and is thinking of installing an anaerobic digester to convert manure and organic waste to natural gas. The gas can be used to power the operation and will contribute added revenue, with sales of any extra natural gas to the grid.
- anaerobic digester costs $500,000
- annual power costs drop $20,000
- annual sales of natural gas total $60,000
The payback period is simple to use and interpret. An unacceptable payback period may mean re-thinking the project. For this reason, it’s an important tool for businesses facing liquidity issues, by providing insights on the projects most likely to return capital outflows quickly.
The payback period ignores the time value of money. As the old saying goes, a dollar today is worth more than a dollar tomorrow. What this means in the context of the payback period is that one should discount future cash flows based on how risky the project is and to consider the effects of inflation over time.
Introducing the discounted payback period
Example #2: Similar situation as before, except that future cash flows are discounted at a rate of 5% per year. This not only reflects the cost of capital for the business (whether funds are borrowed or financed with the business’ internal funds), but it should also reflect the risks associated with the investment.
The discounted cash flow in year one is $76,190, and $72,562 in year two, etc. Therefore, after receipt of the eighth payment, the project will have a positive balance. Therefore, the discounted payback period is sometime during the eighth year.
These methods don’t account for cash flows after the (discounted) payback period. But they are a first step in determining the viability of an investment before proceeding with further research and planning.
Blair Baillargeon, Economics student intern