See Also:
Payback Period Method
Bailout Payback Method
Rule of 72
A new piece of equipment could pay for itself in three years. Is that enough reason to approve it? Payback period tells you when the initial cash outlay is recovered. Net present value (NPV) asks a different question: what are the project’s future cash flows worth today? Both can inform the decision, but they may point to different conclusions.
NPV vs. Payback Period: What’s the Difference?
The payback period measures how long it takes for a project’s expected cash inflows to recover its initial investment. NPV discounts expected future cash flows to their present value, then subtracts the initial investment.
| Payback period | Net present value | |
|---|---|---|
| Result | Time needed to recover the investment | Estimated value in dollars |
| Cash flows considered | Cash flows through the recovery point | Expected cash flows over the forecast period |
| Time value of money | Not included in simple payback | Included through a discount rate |
| Main use | Assessing how soon cash is recovered | Assessing estimated value after the cost of capital |
How Do You Calculate the Payback Period?
When expected annual net cash inflows are equal:
Payback period = Initial investment ÷ Annual net cash inflow
For example, a $100,000 investment expected to produce $30,000 in net cash inflow each year has a simple payback period of 3.33 years. When cash inflows vary by year, add them period by period until their cumulative total recovers the initial investment. For more detail, see Strategic CFO’s Payback Period Method guide.
Why Can NPV and Payback Lead to Different Decisions?
Suppose that $100,000 project produces $30,000 at the end of each year for four years. It recovers the initial investment during year four. But at a 10% discount rate, its NPV is approximately negative $4,904.
Simple payback does not discount those annual cash flows. It also stops its analysis once the investment is recovered. NPV accounts for the timing of the expected cash flows across the four-year project. This is why meeting a payback target does not necessarily mean a project creates value at the company’s required return.
When Should You Use Each Method?
Payback is useful when management needs to know how long cash will be tied up in a project. NPV is useful for assessing the project’s estimated value using a discount rate. Reviewing both can show a tradeoff between near-term cash recovery and the return expected over the project’s full life.
Both results depend on the cash-flow forecast. Before making a decision, review the assumptions behind the investment, including costs, expected savings or revenue, project life, and the discount rate used for NPV. For a fuller explanation of that calculation, see the Net Present Value Method.
Evaluate Your Next Investment with Confidence
A payback calculation can show when cash returns, but the decision also depends on the forecast behind it. Strategic CFO’s financial and operational reporting and CFO consulting support can help you assess cash flow assumptions and compare investment options.
Contact our team to review a project you’re considering.
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For additional information on NPV, please read Net Present Value Method.
