The payback period is the time it takes for a project’s cash inflows to add up to its initial outlay. Discounted payback does the same using cash flows discounted at the required rate of return, so it is always longer. Both are quick screens for liquidity and risk, but neither looks at cash after the payback point, so they should support an NPV calculation rather than replace it.
What is the payback period?
Payback asks a simple question: how long before we get our money back? It is one of the four standard investment appraisal methods in the ACCA Financial Management syllabus, alongside accounting rate of return, net present value and internal rate of return. Owner managed businesses use it heavily because it is easy to explain, needs no discount rate and speaks directly to the worry of having cash tied up.
Government guidance uses it too. The Energy Savings Opportunity Scheme (ESOS) guidance for large undertakings describes the payback period as the estimated cost of implementing an energy saving opportunity divided by the estimated annual energy cost saving, giving an approximation of the number of years over which the cost is recouped. For each opportunity the ESOS energy audit must, so far as reasonably practicable, calculate a payback period, although the guidance prefers life cycle cost analysis whenever practicable.
How do you calculate simple payback?
Where the annual inflow is the same every year, divide the outlay by the annual inflow. A £6,000 lighting upgrade saving £2,000 a year pays back in three years.
Where inflows vary, build a cumulative cash flow:
- Start with the outlay as a negative balance at time 0.
- Add each year’s net cash inflow to the running total.
- Find the year in which the total turns positive.
- Assuming cash arrives evenly through that year, the fraction of the year is the shortfall at the start of the year divided by that year’s inflow.
Use cash, not profit. Depreciation is not a cash flow, and the outlay is already counted at time 0. Include extra working capital as part of the outlay if the project needs it.
What does a worked example look like?
Illustration only. Project P costs £40,000 and is expected to generate net cash of £12,000, £14,000, £16,000, £10,000 and £8,000 over five years. The business’s required return is 8%.
| Year | Cash flow (£) | Cumulative (£) | Factor at 8% | Present value (£) | Cumulative PV (£) |
|---|---|---|---|---|---|
| 0 | (40,000) | (40,000) | 1.000 | (40,000) | (40,000) |
| 1 | 12,000 | (28,000) | 0.926 | 11,111 | (28,889) |
| 2 | 14,000 | (14,000) | 0.857 | 12,003 | (16,886) |
| 3 | 16,000 | 2,000 | 0.794 | 12,701 | (4,185) |
| 4 | 10,000 | 12,000 | 0.735 | 7,350 | 3,165 |
| 5 | 8,000 | 20,000 | 0.681 | 5,445 | 8,610 |
Simple payback: £14,000 is still outstanding at the start of year 3, and year 3 brings in £16,000, so payback is 2 + 14,000 ÷ 16,000 = 2.875 years, roughly two years and ten and a half months.
Discounted payback: £4,185 of discounted value is outstanding at the start of year 4, and year 4 brings in £7,350 of present value, so discounted payback is 3 + 4,185 ÷ 7,350 ≈ 3.57 years. The final cumulative figure of £8,610 is the project’s net present value at 8%.
What is discounted payback and why use it?
Simple payback treats £1 in year 3 as worth the same as £1 today. Discounted payback corrects that by applying the same discount factors used for net present value before accumulating. It answers: how long before the project has repaid its cost and earned the required return on the money while it was outstanding?
Two useful properties follow. A project that achieves discounted payback within its life has a positive NPV at that rate, because the cumulative discounted total ends above zero. And the gap between simple and discounted payback widens as the discount rate rises or the cash arrives later, which is a quick signal of how sensitive the project is to the cost of money.
What are the limitations of payback?
The ESOS guidance (Appendix C, section C6.4) lists the main drawbacks of simple payback in plain terms. It:
- cannot compare complex measures where costs and savings vary in size and timing;
- does not account for benefits and costs after the equipment has paid for itself, so it can disadvantage projects with long useful lives;
- does not account for maintenance costs, interest on loans, disposal costs or volatile utility costs;
- can make economically sound improvements look unviable.
To that list add the general points:
- Cash after payback is ignored. Project Q, costing £40,000 and returning £20,000, £20,000 and £2,000, pays back in exactly two years, faster than Project P. Yet at 8% its NPV is minus £2,747, while P’s is plus £8,610. Ranked on payback, the business would choose the project that destroys value.
- The cut off is arbitrary. A rule such as “everything must pay back within three years” has no link to the cost of capital or to what the business is trying to achieve.
- No measure of total value. Payback gives a time, not an amount, so it cannot say how much better one project is than another.
- Timing within the period is ignored by simple payback: £14,000 in year 1 and £0 in year 2 counts the same as the reverse.
When is payback still useful?
The ESOS guidance says simple payback can be enough for relatively inexpensive, simpler measures, particularly those with a short asset life and little capital or maintenance cost, and that it is easier to communicate to a non technical audience. For costlier or longer lived measures it points to life cycle cost analysis, which expresses results as NPV, IRR and cash flows.
Payback also has a genuine role where:
- cash is tight and the business needs the money back quickly to meet loan repayments or seasonal pressure, so it sits naturally alongside a cash flow forecast;
- the market or technology is changing fast and forecasts beyond two or three years are little more than guesses;
- a lender or investor asks for it as one of several measures.
Used this way, payback is a constraint (for example, “positive NPV and discounted payback within four years”) rather than the decision rule itself.
What mistakes come up most often?
- Using profit instead of cash, so depreciation is deducted and the outlay is effectively counted twice.
- Assuming cash arrives evenly through the year when it is in fact seasonal or arrives in one lump at the year end, which can overstate how quickly payback is reached.
- Leaving out tax. For a company, the tax relief from capital allowances such as the annual investment allowance can arrive early and shorten payback, while tax on extra profits lengthens it.
- Forgetting ongoing costs, such as maintenance or software subscriptions, that reduce the net annual saving.
- Comparing a payback figure with a target that has never been reviewed against the business’s actual cost of finance.
- Treating payback as a measure of profitability. It measures speed of recovery and, indirectly, exposure to risk. Pair it with sensitivity analysis to see how payback moves if savings fall short.
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Sources
- ACCA: Advanced investment appraisal
- GOV.UK: How to comply with the energy savings opportunity scheme esos phase 4
- GOV.UK: Appendix c advice for complying with esos
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.