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payback period

Math problem
New answer on Nov 30, 2021
2.3 k Views

Is payback period calculated in terms of investment (additional profit) or investment (cost-savings) or investment / (additional revenue)?

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Hi there,

The payback period refers to the time needed to recoup an investment. Besides the initial investment, you should take into account the cash flow generated.

Let’s say that you have the following:

I = Initial investment

CF = Yearly cash flow of the investment

Assume for simplicity that the yearly cash flow is constant and there is no time value of money.

The payback period would be :

Payback period = I / CF

If the cash flow is not constant or there is time value of money, the formula becomes more complex, due to the fact the cash flow changes every year.

Hope this helps,

Francesco

Payback period (X) is defined by years taken for cumulative net cash flow from project C = PV + (C1+C2+C3… per year) such that C becomes just positive - which means that your annual cash flows have finally recovered the initial investment (PV).

(edited)

Technically it's none of the options. It's about cash flow.

Cash flow refers to the money coming in and going out of business. Profit is about the money that remains after you paid all expenses related to the revenue.

If a customer buys something on credit, you'll only receive the next year. If you pay for some inventory but don't sell it this year, you have an expense that is not recorded as cost. And you also have D&A which is not a cash expense (e.g. you already paid for that asset a long time ago).

In practice, you have to take net income, add D&A and adjust to changes in working capital (receivables, collections and inventory). The whole formula is a bit more complex, but for cases I doubt you need to know more than this.

Hi there,

This is indeed an interesting, very specific question, so I am happy to provide my perspective on it:

• Generally speaking, it is neither as payback period normally refers to cashflows (both for the initial investment and the annual cash flows).
• Given your options, I would advise you to go with profits as this would be closest to cashflows as opposed to the other options.
• If possible, I would advise you to discuss with the interviewer how the client defines payback period. Indeed, it is very important to clarify the goals of the client (i.e. “What does success look like”) and the metrics (i.e. “How is success measured”).

In case you want a more detailed discussion on how to best approach the beginning of a case study interview, please feel free to contact me directly.

I hope this helps,

Hagen

My suggestion would be that in an interview situation you discuss the definition with the interviewer. Sometimes it happens even when serving clients that the way they calculate a certain formula might be different from the industry standard. So it's always recommended to bring in your perspective, say that this is how you would calculate it, and whether they agree with your definition or they have something else in mind. No interviewer would mind this as long as you're confident and a good communicator.

This is yet another reason why it's critical to discuss your logic of calculations with the interviewer when going through a case, rather than calculating everything directly. Best of luck :)

Hi there,

Payback period is essentially saying “How long will it take all of my benefits to outweight my costs”

Costs are your upfront investment AND recurring costs. Benefits are revenue uplift and/or cost reduction.

You have to essentially say “how much do I get back each year that I would not have otherwise” and divide whatever you have to spend by that number.

^I'm putting this in layman's terms for you, but please go and actually learn the formula and put it into practice with cases!

.

Hi!

It would be investment over cash flow (usually incremental profit) assuming cash flow stays constant throughout the year.

Hope this helps.

Best,

Anto

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