When does the oven pay for itself?: Lena's Bakery Ltd plans to buy a second deck oven for Mill Lane in 2026. It costs $45,000.
Marco's first question: Marco's first question is not whether it is a good oven. It is: how long until the cash it brings in has paid back the $45,000?
That length of time is the payback period: how long an investment takes to bring in enough cash to cover what it cost.
The cash counted each year is the investment's net cash flow: the extra cash it brings in, minus the extra cash it costs to run that year.
The oven's net cash flow each year
Extra cash in: $30,000
More loaves and rolls for the cafés and hotels that buy wholesale, baked on the same night shift.
Extra cash out: $9,000 + $3,000
Ingredients at 30 cents of every sales dollar (3.3.4): $9,000. Gas and servicing for the oven: $3,000.
Net cash flow: $18,000 a year
$30,000 − $9,000 − $3,000 = $18,000. This is the figure payback counts.
When the net cash flow is the same every year, one division gives the answer:
Payback period = cost of the investment ÷ net cash flow per year
$45,000 ÷ $18,000 = 2.5 years. Half a year is 6 months, so the oven pays for itself in 2 years and 6 months.
Payback has no formula on the formula sheet, so learn the steps.
| Answer in years | The part year × 12 | Payback period |
|---|---|---|
| 2.5 years | 0.5 × 12 = 6 months | 2 years and 6 months |
| 4.25 years | 0.25 × 12 = 3 months | 4 years and 3 months |
| 3.33 years ($60,000 ÷ $18,000) | 0.33 × 12 = 4 months | 3 years and 4 months |
A number is not an answer: 2.5 on its own does not say 2.5 what. Write 2.5 years, or better, 2 years and 6 months.
And 2.5 years is not 2 years and 5 months: the decimal is a share of a year, so multiply it by 12.
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A shop that grows: The fourth shop on Station Road costs $120,000 to fit out. It will not bring in the same cash every year: at first few people know it is there, and sales build as word spreads.
Lena's forecast: Lena's forecast of its net cash flow is $30,000 in year 1, then $32,000, $34,000, $36,000 and $38,000.
With different figures each year, one division no longer works. Instead, keep a running total of the cash that has come back (the cumulative cash flow) and find the year in which it passes the cost.
Some tables start the running total at minus the cost, in a year 0. Then payback falls in the year the total turns from negative to positive. Both layouts give the same answer.
| Year | Net cash flow | Cumulative cash flow | Running total from −$120,000 |
|---|---|---|---|
| 1 | $30,000 | $30,000 | −$90,000 |
| 2 | $32,000 | $62,000 | −$58,000 |
| 3 | $34,000 | $96,000 | −$24,000 |
| 4 | $36,000 | $132,000 | $12,000 |
| 5 | $38,000 | $170,000 | $50,000 |
Worked example: the Station Road shop
Find the last full year before payback
After 3 years, $96,000 has come back: short of $120,000. After 4 years it is $132,000. So the shop pays back during year 4.
Work out what is still to recover
$120,000 − $96,000 = $24,000 still to come back at the start of year 4.
Turn it into months of year 4
$24,000 ÷ $36,000 × 12 months = 8 months. Year 4's cash is taken to arrive evenly, $3,000 a month.
Put it together
Payback period = 3 years and 8 months (or 3.67 years).
As a line of working:
Payback period = full years + (amount still to recover ÷ net cash flow in the payback year) × 12 months
3 years + ($24,000 ÷ $36,000) × 12 = 3 years and 8 months.
Three slips that cost the answer: Dividing by the wrong year. The $24,000 comes out of year 4's $36,000, not year 3's $34,000.
Stopping at the year. 'Payback is in year 4' is only half an answer. The full one is 3 years and 8 months.
No working, no unit. Show the running total, the subtraction and the months, then write years and months.
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3 years and 8 months: is that good?: The figure alone does not decide. Payback answers one question only: how soon. It says nothing about how much the shop earns in total.
Why speed matters to Lena: Lena still owes $350,000 on the bank loan and has a $30,000 overdraft limit, so how fast cash comes back matters to her.
What payback does well
- Quick to work out and easy for Lena, Marco and the bank to follow
- Built on cash, which matters to a business with a $30,000 overdraft limit
- A shorter payback leaves less time for forecasts to go wrong
What it leaves out
- Cash after payback: the shop's $38,000 in year 5 does not count at all
- Total profit: how much the investment earns over its whole life
- Timing: a dollar in year 4 counts the same as a dollar today
- Certainty: it is only as good as the forecast, and a new shop's sales are a guess
When it is the right test
- Cash is tight and the money is needed back soon
- Technology or tastes change fast, so later years are hard to forecast
- As a first check, to rule out projects that take too long
Why does timing matter? A dollar that arrives in four years is worth less than a dollar today. Cash in hand now could pay off the overdraft or earn interest, and prices rise in the meantime. Payback counts every dollar the same, whenever it arrives.
And the cash after payback can be large. By the end of year 5 the running total for Station Road is $50,000 above the cost, and the shop should trade for years after that. Payback counts none of it.
Put the figure next to something: A payback period means more when it is compared with how long the asset lasts, a target the owners set, or when a loan must be repaid.
The oven: The oven pays back in 2 years and 6 months and should bake for ten years or more, so most of its life earns after payback. An investment whose payback is longer than its life never pays for itself.
How this comes up: A table of an investment's cost and its yearly cash flows, then: calculate the payback period, showing all your working, for two marks.
Variations to watch for
- Sometimes a yearly running cost has to come off each figure first.
- Sometimes you are told the yearly figure stays the same.
- Now and then it is one mark with no working asked for. Then the answer, with its unit, is everything.
The pattern for a payback calculation
- Get the net cash flow for each year. Take off any yearly running cost the question gives.
- Keep a running total until it passes the cost, and name the last full year before it does.
- Divide what is still to recover by the next year's net cash flow, then multiply by 12 for months.
- Write the answer with its unit: years and months, or years to two decimal places.
Two traps: An answer with no unit. 3.67 on its own is not a payback period. Write 3 years and 8 months, or 3.67 years.
Counting the payback year as a whole year. 'Four years' for Station Road is too long: the cost is back 8 months into year 4.
Using the table, calculate the payback period for the Station Road shop (show all your working).
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.