How to Calculate Payback & NPV

NPV and payback periods are calculations used with capital projects.
NPV and payback periods are calculations used with capital projects. (Image: Hemera Technologies/ Images)

When a company is planning a project, it often looks at and calculates the payback period and the NPV (net present value). These two calculations help companies determine whether a project will be beneficial to complete. A payback period determines how long it will take to recoup the investments made on the project. NPV refers to the difference between the amount of the investment and the present value of the expected future cash flows from the project.

Calculate Payback Period

Begin with the cost of the project. To calculate the payback period, you must know the entire estimated cost of the project. For example, the project you are considering will cost $12,000.

Determine the annual cash flows. Look at the length of time cash is expected in terms of incoming cash. Create a chart to write down the expected cash flows for each year. For example, assume a project expects to receive cash flows for five years at $3,000 a year.

Calculate the payback. This shows how long it will take for the company to break even based on project costs and cash inflows. In this example, it will take four years to break even. This is calculated adding the first four years of cash inflows together, $3,000 times 4. This totals $12,000.

Calculate NPV

Understand the concept of NPV. To calculate it, you must discount the cash flows because money received in the future is not equivalent to money received now. Money that is received now is actually worth more money than future returns.

Discount the returns. Assume that the cost of capital is 10 percent. Each year must then be discounted to calculate what it is worth today. To calculate NPV by hand is difficult; many online calculators are available for this purpose.

Log on to Data Dynamic. The easiest way to calculate NPV is to simply input the correct information in. When this example is used, the calculator totals NPV of this project to be - $2,490.40.

Determine if the project is worthwhile. According to this calculation, NPV is a negative number. Normally, if projects have a negative value NPV, the project will cost more for the company than it is worth.

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