How to calculate payback period in business plan

What is the payback period of business?

The average payback period of business a few years ago was one or two years. Presently, these figures aren’t relevant. Business activity of small and medium-sized businesses does not have very bright prospects for development. This is especially true of business organized in big cities.

The average payback period of the restaurants and cafes in a big city is about seven years. Designing a business plan it is necessary to take into account the peculiarities of the market and not build highly optimistic forecasts with a short payback period. Investors will not believe in such business plan.

It should be noted that the average payback period of business is about five years. This period should be considered calculating the planned indicators.

An increase of the payback period is observed in capital investments too. Class A premises are redeemed during a period of 8 to 10 years, while low-yield premises can be redeemed for 20 years or even more, or remain unredeemed at all.

That is why the purchase of premises should not be put into an investment program, since such significant payback period will not be of any interest to the investor. It makes sense to buy premises at your own expense.

Payback norms

There are no established standards on the payback period in business but the average statistics data exist. It is believed that a large business has a payback period of 10-12 years, while the same indicator for a medium-sized business is about 5 years. Small business, depending on the area of activity, may have a payback period of up to six months. As a rule, this refers to a business that does not require significant financial investments, i.e. a service sector.

How to calculate the payback period in a business plan

The payback period is determined as the ratio between the amount of investment and the discounted net cash flow.

where

  • INV – volume of investments made for a certain period.
  • CF – net cash flow.

CF  =  ICF – OCF

  • ICF – input cash flows during a certain period;
  • OCF – output cash flows covered during a certain period.

Read here how to calculate the discounted cash flow.

The discounted payback period of the investments (DPP) is a period during which the amount of discounted cash flow equals the amount of invested funds.

Where

  • r – discount rate;
  • t – number of periods for which the cash flows are investigated.

As well as the calculated method of determining the payback period, the discounted one has a major negative moment, i.e. it does not take into account the cash flows arising after the payback period. Therefore, it can not be affected by the whole return on investment during the entire investment period.

Investors use this indicator not as a basic but as a limiting one. If the discounted payback period is higher than the one planned, then such object is not considered as favourable for investing.

Let’s consider the calculation of the payback period in an Excel sample of a business plan.

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