The payback period is a measure of the time it takes for an investment to recoup its initial cost. It is the length of time it takes for the cumulative cash flows from an investment to equal the initial cost of the investment. The payback period is often used as a simple method for evaluating the attractiveness of a potential investment.
Here is an example to illustrate how the payback period works:
Suppose you are considering investing in a project that has an initial cost of $100 and is expected to generate cash flows of $50 at the end of year 1, $60 at the end of year 2, and $70 at the end of year 3. To calculate the payback period for this project, you would need to determine the cumulative cash flows over time. In this case, the cumulative cash flows would be:
- End of year 1: $50
- End of year 2: $50 + $60 = $110
- End of year 3: $110 + $70 = $180
Since the initial cost of the project is $100 and the cumulative cash flows reach this amount at the end of year 2, the payback period for this project would be 2 years. This means that it would take 2 years for the project to generate enough cash flows to recoup the initial investment.