In the conditions of accumulation of a sufficient amount of capital (one might even say, the appearance of some excess capital that cannot be used in one's own business), private individuals and financial institutions are thinking about how to make available temporarily free money work, because it is the self-growth of capital that is its main function . In order to understand how quickly the entrepreneur will start to profit from the money invested, the payback period of the investment is calculated. That this indicator means and how it can be calculated, we will tell in this article.
The payback period of investments shows at what point the income from the investment will exceed the amount of the investment itself and the project will start to generate net profit. The calculation of this indicator is important for the investor, because it gives him the opportunity to assess the risk of the project and the time during which he will not be able to use the invested resource.
We give a simple example. If a million dollars is invested in the project, and the amount of annual income is one hundred thousand dollars, then the payback period of investments will be ten years. At first glance, it might seem that the faster the project pays off, the more willing it will be to invest money, but in reality this is not entirely true, and we will explain why below.
Calculation of the payback period of investments is the most important procedure preceding the adoption of a decision on participation or refusal to participate in a particular project. Depending on the duration of the project, different approaches may be used:
- If the projects are short-term (up to a year), the usual payback period for investments is calculated - the private division of the invested amount by monthly income. This procedure allows you to calculate when we receive our money in the so-called future value.
- If the project is designed for several years, it is advisable to calculate the discounted payback period for investments, which allows us to evaluate when we will return the invested money at current cost. The difference between current and future value is that money is subject to inflation, that is, depreciation. Thus, a million dollars today, you can buy more real values than the same million dollars in ten years. In order to understand when we will return the invested amount in real value at the time of investment, it is calculated the discounted payback period. The calculation of this indicator for short-term projects does not make sense, since in a more or less stable economy, inflation for the year is about 5-7 percent, and in the conditions of tight deadlines it will change them at best for several weeks, which is not a deadline for large business, taken into account. The discounted term is conveniently calculated as follows: multiply the simple term by the sum of a unit and the average annual inflation rate raised to a degree equal to the number of years of investment.
Along with cash flow, the future and present value of money, the payback period of investments is one of the most important indicators used in the work of an investment manager. It is worth noting that a faster payback is usually associated with greater risks - the higher the rate of return, the more dangerous moves you have to make in order to achieve it. Thus, not every investor will be too anxious about a rate of return of 300% per annum and payback in four months - it is too likely that his investments will simply burn out as a result of unforeseen circumstances or the manager’s recklessness. Investments with lower returns and longer paybacks, on the contrary, inspire greater confidence.