### How to Calculate Payback Period

In previous posts, I went over how to calculate the internal rate of return and how to discount future cash flows to arrive at a net present value. Today, I’ll go over another way you can evaluate projects, and that’s using the payback period. The payback period calculation is a simpler method than the other two approaches in that it just looks at how long it’ll take for you to recoup your money from an investment, or when you’ll hit breakeven.

To do this calculation, I’ll again use the discounted cash flow spreadsheet from my earlier example. The key difference in calculating the payback period is that you don’t need to worry about present value since this won’t take into account the time value of money.

Let’s assume a scenario where you invest \$1,000,000 into a project and generate cost savings of \$100,000 every year. Here’s how that might look like over a 25-year period:

This is a really simple setup but let’s set up a formula to determine when the investment reaches breakeven. In this scenario, since the cash savings are always \$100,000 every year, you can simply take the initial investment and divide it by the annual cost savings. The formula looks as follows:

After 10 years, the investment will be paid back in its entirety and reach breakeven. If your cash flows will vary over the years, what you can do is use an average to try and smooth it out and get to an approximate payback period. Another alternative is to create another column that shows your cumulative savings or cash inflows and how much is left to reach breakeven. To calculate a cumulative sum, just use a regular summation formula but freeze the first cell so that your formula will always start from the same position. Here’s how you might set this up:

You’ll see that cell C6 is frozen as that’s where my first value is, and that’s where the \$1,000,000 outflow of cash is. I’ve also changed my cash flows so that they’re different amounts each year, and under this scenario, you’ll notice that it’s not until year 22 that I reach breakeven. A better way to illustrate this is through conditional formatting, by highlighting the negative values and the positive ones in different colors.

You can do this by selecting all the values in the cumulative field and under Conditional Formatting, selecting Format all cells based on their values, which gets you to this menu:

The first thing I’ll do here is to change the color scale so it shows three colors instead of just two. Then, I’ll set it up so that the lowest value is red, the midpoint is set to 0 and white, and the maximum is set to green:

Then, after clicking on OK, my values look like this:

Using the conditional formatting, I can easily see the progression of the red into white (breakeven), and then into green. It’s a lot easier on the eyes and allows you to quickly see the progress. If you want to look into more ways you can do this, check out this post on conditional formatting.

## Payback period when factoring in time value

If you just want to calculate the payback period using a simple formula and your cash flow / savings is the same every year, then simply dividing your total investment by that amount will suffice. Then, it’s simply a matter of determining whether the number of years in the payback period is acceptable to you. If it is, you can move forward with the project. If the payback period is too far into the future, then you may want to re-consider it.

However, when you’re looking at a longer timeframe, you may want to consider incorporating discounted cash flow to give you a more realistic picture of the payout period over time. And while the typical payback period calculation doesn’t incorporate the time value of money, that doesn’t mean you can’t do it. In this example, I’ll calculate the present value of the cash flows like I did in the earlier post which looked at discounted cash. Using a discount rate and raising the cash flow to a negative power (years in the future), I can arrive at the present value. Here’s how that looks in an additional column, with the respective formulas off to the right:

Note that I used a named range for the discount rate. Column B relates to the Year field and Column C is the cash flow value in the future.

This time I use Excel’s built-in present value function, which requires you to enter the rate, the number of periods, payments (not applicable here), and the future value (which needs to be negative for this to calculate correctly). Using a 5% discount rate, I’ve populated the present values of each of the future cash flows.

Now, I can add a column to track the cumulative values:

When factoring in the time value of money, my payback period is now well over 25 years. It’s an important reminder of just how important time value is. Under the previous payback period calculation that didn’t factor in the time value of money, the payback period was 22 years. In order for my payback period in this example to get to breakeven within 25 years, I’d have to set my discount rate to less than 1%. At 0.5%, this is what the schedule looks like:

Only after 24 years does the project attain breakeven in this situation, and that’s with a minuscule discount rate. Normally, in a payback period calculation, you’ll just stick to the investment total divided by the savings or cash flow that the investment will generate. However, there are significant drawbacks to doing so when it may take many years for an investment to breakeven. In that case, it may be worthwhile to consider the time value of money.

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### How to Calculate Internal Rate of Return (IRR) in Excel

Last week, I covered how to calculate discounted cash flow. In this post, I’ll build off that worksheet and show you how you can calculate the internal rate of return (IRR) in Excel. IRR tells you the return that you’re making on an investment or project, and at what discount rate the net present value of all the cash flows will be zero. In these scenarios, there’s typically an outlay of cash, usually at the beginning.

In my previous example, I only looked at cash flows coming in. This time, I’ll look at a scenario where you pay money out at the beginning and generate cash flow in future periods. A common example is paying to upgrade a piece of equipment and then generating cost savings from it for x number of years. Knowing the IRR can tell you if you’re making enough of a return off of the investment and whether you should move forward with it. Using IRR can also be helpful when you’re comparing multiple options to see which one is the best one.

This step is about the same as when setting up the discounted cash flow template. You’ll need to enter the different years, the cash you expect to come in or out, and then calculate back what the present value is today.

Here’s what the file looks like setting in a scenario where you pay \$100,000 upfront and then generate \$10,000 in cash flow for 25 years. At a 5% discount rate, in this example the present value of all that cash flow is a positive \$40,939.45:

## Calculating the IRR

The problem here is the discount rate can be difficult to determine, and that can have a significant impact on your overall returns. And so rather than worry about what your discount rate should be, you only need to determine the IRR — which is to say at what point would your present value be worth \$0? If you need a higher return than the IRR the project would be a no-go but if you’re okay with anything up to and including the IRR, then the project or investment would be passable. What it comes down to is the lower the IRR is, the worse the investment is

There are a couple of different ways to calculate IRR in Excel. One way is through a formula called XIRR. It only has two required arguments — dates and cash flow. This is why in this example I entered dates for my cash flows rather than just numbering the years. This makes it easier for me to use the XIRR formula. In my spreadsheet, I enter the following formula:

=XIRR(D6:D31,C6:C31)

Column D contains my cash flow and column C contains the dates. Doing this, Excel tells me the IRR is 9.687% for this specific project. But if I work backwards and calculate the net present value, it doesn’t get me right to 0:

It certainly gets close to 0 and it’s probably close enough that it can help you make a decision about your investment. However, there’s another way to calculate IRR and that’s using Excel’s What-If Analysis. On the Data tab, there’s a drop-down for this option in the Forecast section:

Depending on which version of Excel you’re using, it may show a bit differently, but what you’re ultimately looking for is Goal Seek.

Goal Seek is an accelerated way of doing trial-and-error. Excel’s doing it for you much quicker than you could ever do it by yourself. For IRR, it’s the best solution.

Here’s how it works. You’ll need to enter the cell that you want to get to a certain value, what value that is, and which cell Excel should be changing values in. In my spreadsheet, E2 is where my net present value formula is, and I want that to equal 0. In cell B2 is my discount rate, which is what I want Excel to be changing. Here are what my inputs look like:

Then, once I click on OK, Excel goes to work. After a few seconds you should see Excel show you that the target value and the current value are a match (e.g. they’re both 0), meaning it’s done its job successfully:

Now, if I look at my template, I see a different discount rate and my total present value is netting out to 0:

As you can see, this is much more accurate than Excel’s XIRR function. You can repeat these steps and make this table for other projects that you can assess side-by-side.

If you’d like to test this out, try downloading the discounted cash flow spreadsheet from my last post and then just using Goal Seek or the XIRR function to determine your IRR. You can remove unnecessary columns from the sheet and then duplicate the table, and then you’ve got a template where you can assess multiple investments against one another.

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### How to Calculate Discounted Cash Flow in Excel

Do you need to calculate the present value of future cash flows or assess two options that will impact your cash flow over many years? Excel’s a great place to do that and below I’ll show you how you can easily set up a template to calculate discounted cash flow that you can adjust for changes in the discount rate and cash flow. And if you don’t want to create your own template, you can download mine at the bottom of this post.

In this example, I’ll compare a lump sum lottery win versus a scenario where you receive an annual amount for 25 years. Step one is knowing to calculate present value, which is what I’ll cover next:

## Calculating the preset value

To calculate the present value of future cash flow, you need to know what discount rate to use. What you can use is the rate that you can earn on a typical investment. For instance, if you invest in stocks and assume you can make 5% per year, on average, then you might want to use that as your discount rate. If you want to be more conservative, you could use a rate of 2%. Below, you’ll see how the discount rate can play a big impact in your calculations.

That’s because when calculating today’s present value, you have to use the discount rate to bring the future value back to what it would be worth today. For example, suppose you were to receive a \$10,000 payment a year from now, and your discount rate was 5%. An easy way to calculate this is as follows:

You might see other formulas on the web involving fractions to calculate present value but just using a negative power does the trick. This calculation yields a result of \$9,523.81. Because you’re not getting the payment today, the value of that money is worth less than the full amount. Consider that if you were to receive \$10,000 today and invest it and earn 5%, then a year from now it would be worth \$10,500 — more than if you were to receive the \$10,000 in a year.

Now, suppose you used a discount rate of just 2%. In that scenario, the \$10,000 payment a year from now would be worth \$9,803.92 today. Since the discount rate is lower, there’s less of a cost associated with waiting for your payment. If the discount rate was 0%, then there would be no incentive for you to invest your money since a year from now it would still be worth the same value it is today. That’s why when interest rates fall and get closer to zero, people will be less inclined to keep their money at the bank and there’s more demand for gold — since that can be a better way to store wealth at that point.

## Creating a template to calculate discounted cash flow in Excel

Now that we’ve gone over how to calculate discounted cash flow in Excel, we can set up the template. All that’s really necessary here is to map out the payment schedule, including how much cash you’ll receive every year. Here’s an example scenario of receiving \$100,000 for 25 years:

All the payments don’t have to be the same, but for the lottery example, I’m going to keep them that way. What I can do is create another column that will tell me the present value of each one of those payments. To do that, I’ll use a formula that takes the cash flow value, multiples it by the discount rate (I’ll use 5%) raised to a negative power (the year). Here’s how that looks:

I created a discount rate named range so that it’s easy to reference the percentage and to change it. The only thing left here is to calculate the total of all these payments, to arrive at the present value of all of them:

The total present value of the payments comes in at just over \$1.4 million. Even though the total of all the payments over 25 years is \$2.5 million, we’re losing a lot of that value because of the time value of money, at a rate of 5% per year.

However, let’s prove this out, and to do that let’s look at the future value of all these payments. Let’s assume that these funds will be reinvested and earning a rate of 5% every year. Here’s how much we’d have by the end of year 25:

In this situation, we’re benefitting from compounding and earning 5% on each year’s ending balance, which includes the prior-year return. By the end of year 25, if we were to invest all of these \$100,000 payments at a rate of 5%, we’d have a future ending value of \$4,772,709.88.

Now, remember, the equivalent of these annual payments is a present value of \$1,409,394.46. Let’s assume that rather than receiving annual payments of \$100,000, we simply receive a lump sum payment of this and invest it and also earn 5% every year. Here’s how that will look like:

The ending value after 25 years is the same, \$4,772,709.88. This tells us that if you’re given the option of 25 annual payments of \$100,000 or a lump sum of \$1,409,394.46 today, there’s no difference to you (if the discount rate you’re using is 5%). If the discount rate is 2%, then the present value climbs to \$1,952,345.65.

As you can see, depending on which discount rate you use, it can have a significant impact on your present value calculations. This template will allow you to quickly change the discount rate and see how the calculation looks under different scenarios. You can also add more years to this calculation by just extending the formulas down. The amounts also don’t need to be identical, they were only set up this way purely for the purpose of comparing lottery winnings in a scenario where you earn one lump sum amount versus equal payments over multiple decades.

If you’d like to download this template to follow along, the free version is available here, which goes up to year 15. For the full and unlocked version, which has no ads and goes up to 30 years, please refer to the product page here.

If you liked this post on how to calculate discounted cash flow in Excel, please give this site a like on Facebook and also be sure to check out some of the many templates that we have available for download. You can also follow us on Twitter and YouTube.

### Cash Flow Forecast Template

This template allows you to monitor and forecast out cash flows for a specified number of days. The current date defaults to today’s date but you can override it manually but if you do the formula will be gone.

You can also change the number of days you want to look in advance. For instance, you may only want to look at the cash you expect to have available for the next 7 days, 14, or however long you want.

First you will want to populate the current balance for each of the accounts. Right now they are hard-coded cells but you can certainly add formulas to populate this. The input section is on the second page of the Summary tab (scroll to the right if you do not see it on your screen)

The cells above in yellow are ones you can edit. The ones in grey are formulas and need to remain the same as they are used in the chart.

There are three main sections in the chart:
– Funds Available
– Upcoming Transactions
– Outstanding Checks

Funds Available is simply a formula to show what cash on hand is expected at the end of the forecasted days. It looks at the current bank balance, deducts upcoming transactions, as well as the current outstanding checks. A positive number indicates the account will have cash remaining at the end of the period. A negative amount indicates that not enough cash is in the account to accommodate all the upcoming expenses and checks to be cashed.

Upcoming Transactions are populated from the Recurring Transactions tab.

You can specify if a recurring transaction recurs monthly or annually. Based on this, along with today’s date, it will calculate the next occurrence of the transaction.

Further down on the Summary tab you can see a breakdown of the largest upcoming expenses on the left-hand side for all the banks and bank-specific transactions on the right-hand side. The yellow cell indicated below can be toggled to another bank and you will see transactions just for that bank. Both of these tables will only show expenses that fall within the date range you specified (e.g. if you specify only the next 7 days, it will only show expenses up until that date).

The Outstanding Checks are fueled by the individual bank tabs. Each tab allows you to list any checks you have outstanding along with their amounts. Note that if you change any of the bank names on the input section you will also have to rename the tab. If the tab name does not match the bank name, the checks outstanding will not populate.

### Cash Flow & Calendar Template

In this post I have attached a simple calendar template that will allow you to generate a new calendar by just changing the month name or year. In addition there is an empty space for each day that by default tracks cash flows (from the data tab). You can enter in dates and cash flows in the data tab and they will populate on the calendar for those days. Of course the formulas can be overridden to put other data in the calendar.

Below is what the template looks like with some sample cash flow numbers filled in

Cash Flow & Calendar Template