Payback Period
How long a project takes to repay its investment, with and without discounting.
How long until cumulative cash flow turns positive, ignoring the time value of money.
Always longer than plain payback, because later cash is worth less. This is the more honest figure.
Payback ignores everything after the cut-off, so a project that repays quickly then loses money scores well. It is a liquidity screen, not a value measure — pair it with NPV.
The payback period is when cumulative cash flow first turns positive. An investment of 1,000 returning 400 a year is fully repaid halfway through year three — 2.5 years. Discounted at 10%, the same project takes about 3.02 years.
The simplest question you can ask
Before asking whether a project is profitable, many managers ask something more basic: how long is my money at risk? The payback period answers that. It counts the periods until the cumulative cash flow crosses zero — the point at which the original investment has been recovered.
Because the crossing usually falls inside a period rather than neatly at its end, the fraction is interpolated. If 800 has been recovered by the end of year two and year three brings 400, the remaining 200 arrives halfway through, giving 2.5 years.
The discounted version
Plain payback treats a dollar in year four as identical to a dollar today, which is exactly the error that discounting exists to correct. Discounted payback applies the discount rate first and then asks the same question. It is always the longer of the two, and sometimes the difference matters: a project that pays back in 2.5 years undiscounted takes 3.02 at a 10% cost of capital.
For discounted payback, discount each cash flow to present value before accumulating. The interpolation assumes cash arrives evenly through the period.
Worked example: −1,000 then 400 a year
Accumulate, then interpolate across the crossing period:
- 1 Start with the investment. Cumulative cash flow at t = 0 is −1,000.
- 2 Add each year in turn. After year 1: −600. After year 2: −200. Still negative, so the investment is not yet recovered.
- 3 Find the crossing period. Year 3 brings 400, taking the cumulative from −200 to +200. The crossing happens during year 3.
- 4 Interpolate the fraction. 200 of the year-3 inflow is needed to reach zero: 200 ÷ 400 = 0.5.
- 5 Add it to the last full period. 2 + 0.5 = 2.5 years.
- 6 Repeat with discounting. At 10% the cumulative reaches −5.3 by year 3 and turns positive early in year 4, giving 3.02 years.
Cumulative cash flow, plain and discounted
The example series, accumulated period by period. Payback is where each column first turns positive.
| Period | Cash flow | Cumulative | Cumulative at 10% |
|---|---|---|---|
| 0 | −1,000 | −1,000 | −1,000.0 |
| 1 | +400 | −600 | −636.4 |
| 2 | +400 | −200 | −305.8 |
| 3 | +400 | +200 | −5.3 |
| 4 | +400 | +600 | +267.9 |
What payback cannot see
The measure stops looking the moment the investment is recovered, and that blindness is its defining weakness. A project that repays in two years and then loses money scores better than one that repays in three and then earns steadily for a decade. Payback has no opinion about anything past the cut-off.
It also has no natural benchmark. NPV has a clear rule — accept above zero — and IRR compares against the cost of capital. A payback threshold of three years is a policy choice, not a result derived from anything.
Used honestly, it answers a liquidity question rather than a value question: how long before the cash comes back, and how exposed are we until it does. That genuinely matters for a firm with tight financing or for a project in an unstable market, where a distant payoff carries risks the discount rate does not fully capture. Pair it with NPV rather than substituting it for one.