All you do is divide Investment by Annual Cash flow to get Payback Period. So suppose if Investment cost is $1,000,000 and Annual Cash Flow expected is $125,000, then Payback Period is 8 years.
However in real world, you can never expect to have a constant Annual Cash Flow every year. So, expected return for each year is added until total cost of Investment is arrived.
|Year||Return||Cummulative Project Cost|
In the table above, Investment cost will be recovered just shy of Five years. So when a Venture Capitalist has three competing projects, he may consider Payback period amongst other things and go for the project that has the shortest Payback Period. As with any other method, this method has a disadvantage that it ignores time value of the money. However if this method is used in conjunction with the Net Present Value and Internal Rate of Return, it is a great tool for the Venture Capitalist.
As an Entrepreneur, when you prepare your projections, you must be careful with your calculations so that decision process is smoother and in your favour. Who knows, when a Venture Capitalist is comparing your project with other projects with similar merits, you may come out as a winner due to your realistic projections.