How many months does an investment take to pay for itself? The payback period

Ayşe Hanım the dry cleaner's new machine

The rules described in this lesson are those of Turkish law.

The machine in Ayşe Hanım's dry-cleaning shop is twelve years old. It breaks down every month, burns a lot of electricity and takes only a small load at a time. The dealer gave her a quote for a new machine: 600,000 TL excluding VAT. The seller says, "This machine pays for itself in a year."

Ayşe Hanım's question is a fair one: "Who calculated that? In how many months does it pay for itself in my shop?"

Think of a piggy bank

An investment is money that leaves the cash box in one go. Every month the machine puts a little money back into the cash box: either by bringing in extra work or by cutting costs. Think of it as a piggy bank. When the money saved in the piggy bank reaches the price of the machine, the machine has paid for itself. This period is called the payback period (geri ödeme süresi).

Formula: investment amount ÷ monthly extra cash brought in by the investment = payback period (months).

Find the monthly extra cash

As in the previous lesson, we look only at the figures that will change (A new employee or a second branch?). The changes Ayşe Hanım expects with the new machine, monthly and excluding VAT:

Payback period: 600,000 ÷ 40,000 = 15 months. With Ayşe Hanım's figures, the seller's "one year" comes out as 15 months. It is not a bad result; but once the details are written into the calculation, the promise changes.

Not profit, but cash

The payback calculation is done on cash, not on the income statement. The difference has a name: depreciation (amortisman), that is, the price of the machine being recorded as an expense not in a single year but spread over the years it will be used (Tax Procedure Law art. 313–315). In the year the machine is bought for 600,000 TL, only part of the price appears as an expense on the income statement. But the whole 600,000 TL left the cash box on the day of purchase. Your mali müşavir (accountant) decides over how many years it is spread by looking at the depreciation list published by the Ministry of Finance.

Depreciation also goes into the tax calculation: because it is recorded as an expense, it reduces tax. So first calculate the payback period before tax, then ask your mali müşavir "what changes after tax?" The difference comes out differently in a sole proprietorship and in a company. If you are under simplified taxation, your income is exempt from income tax, so there is no such tax effect.

What about VAT?

On the machine's invoice, 20% VAT, that is, 120,000 TL, comes on top of the 600,000 TL. Because Ayşe Hanım is a VAT taxpayer, she can deduct this VAT from the VAT she collects on her sales. But she pays the 120,000 TL on the day of purchase; if the VAT on sales is not enough that month, the rest carries forward to the following months (Calculating VAT line by line). So the VAT comes back in the end, but it may not come back straight away. If you are under simplified taxation, or not a VAT taxpayer for some other reason, you have no VAT deduction; then the VAT also becomes part of the machine's cost, and you write the investment amount including VAT in the calculation.

Write three scenarios

The estimate of extra work is the most unpredictable figure. Don't look at a single figure; look at three:

Even in the bad scenario, 24 months. Since the machine's life is over ten years, even the bad scenario looks acceptable. In your own calculation, if the payback period in the bad scenario gets close to the machine's life, stop and think again.

What this calculation can't see

The payback period is a simple measure, and it has limits.

• Money waiting has a cost. If the 600,000 TL hadn't gone into the machine, it could have earned interest in the bank. If the machine is bought on credit, the interest and charges are also deducted from the monthly extra cash. The longer the period, the bigger this gap. A note for readers who know accounting: the methods that close this gap are the discounted payback period and net present value; your mali müşavir can calculate these too.
• The years after it has paid for itself. The payback period tells you the day the piggy bank is full; it doesn't tell you what comes after. A machine that pays for itself in 15 months and works for ten years is a better investment than a machine that pays for itself in 12 months and breaks down two years later.
• Prices change. In a period of inflation both your prices and your costs go up. Do the calculation with today's prices and update it every six months (Updating prices under inflation).

What did Ayşe Hanım do?

She talked to two hotels and a restaurant and got the monthly amount of laundry as a written offer; the estimate stopped being just talk. Finding even the bad scenario acceptable, she bought the machine. She left three months' fixed costs in the cash box as a cash reserve (kenar parası) (The bad-month scenario and the cash reserve), and asked her mali müşavir over how many months the 120,000 TL of VAT would be deducted from the VAT on sales. Whether to find the money from her own cash box, with a loan or through leasing, we compare in the next lesson.