The Payoff Point happens in the year when the PV is greater than the start-up costs. Let’s look an example to see how the payoff costs are calculated.

An Example – the Hotdog Stand
You run a hotdog stand at a local ballpark. You’ve decided to buy a popcorn machine and begin selling popcorn. The machine costs $500, so that’s your start-up costs. You’ve done your PV calculations and believe you will make the following over the first five years:

Y1: $178.00

Y2: $228.00

Y3: $340.00

Y4: $418.00

Y5: $543.00

When will you have paid off your $500 start-up costs? Well, it’s not after year 1, because you only plan to make $178, and that’s less than $500. But you’ve gotten closer. How much of your start-up costs do you have left? $500 in costs, less the $178 you will have made, or $500-$178, leaves you with $322 to payoff at the beginning of year two. Ok, $322 left to pay off. In year 2, you plan to make $228, but that’s not more than the $322 you have left to pay. How much closer are you now? $322 less the $228 you will make in year 2, so that’s $322-$228, or $94. That’s $94 left to pay off, and you plan on making $340 in year 3. That will be enough, so you know you will pay off the machine in year three.

When during year three do you start making a profit?
Look at the difference in the payoff amount you have left in year three, $94, versus the NPV your new popcorn machine will generate, $340. You’ll actually be making profit you can keep during year three. How do you know when that is?

When businesses are dealing with financial matters they divide the year into quarters. Three months – January, February and March, for example – make up one quarter. So when you will be paying off the start up costs and earning profit in the same year, it is best to round your payoff point to the nearest quarter.

Look back at the example and determine when you would start keeping your popcorn profit. You estimate that you’ll make $340 in year 3. Will you pay off your remaining $94 in the first quarter of year 3? Well, that depends on how much you make during that quarter. What’s one quarter of $340? That’s $340 divided by 4, or $85. You had $94 left to pay, so earning $85 per quarter will you pay it off in quarter 1? No. After the first quarter, you’ll still have $9 left to pay off (the $94 you had to pay off that year, minus the $85 you made in the first quarter). Will you pay it off in quarter 2? Yes; another $85 will exceed the $9 you have left to pay off. So you can round your payoff point to say it will take you until the 2nd quarter of year 3 to payoff the popcorn machine. From then on, you get to keep all your profits.

You might have realized that you will earn some money in quarter two; you only needed another $9 to pay off your start-up costs, and you made $85, so you probably will make that $9 pretty quickly during the second quarter. Typically, however, it doesn’t make sense to track pay-off to the day or week; a quarter is good enough for a business to know approximately when something will happen.