620 Notes PDF

PAYBACK PERIOD
CHRISTINE NYANDAT, 19 Nov, 2013
Definition: Payback period is the length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to undertake
the position or project, as longer payback periods are typically not desirable for investment positions.
Calculated as:
Payback Period = Cost of Project / Annual Cash Inflows
In other words:Payback period is the time in which the initial cash outflow of an investment is
expected to be recovered from the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.
Why is it important?Payback period intuitively measures how long something takes to "pay for itself."
All else being equal, shorter payback periods are preferable to longer payback periods. Payback period
is widely used because of its ease of use despite the recognized limitations described below.
Lecture notes
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:
Payback Period = A + B/C
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The project is
expected to generate $25 million per year for 7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in
Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in millions)
Year
0
1
2
3
4
5
Cumulative
Cash Flow
Cash Flow
(50)
(50)
10
(40)
13
(27)
16
(11)
19
8
22
30
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years
Example 1:
Due to increased demand, the management of Rani Beverage Company is considering to purchase a
new equipment to increase the production and revenues. The useful life of the equipment is 10 years
and the companys maximum desired payback period is 4 years. The inflow and outflow of cash
associated with the new equipment is given below:
The initial cost of equipment $37,500
Annual cash inflow:
Sales
$75,000
Annual cash outflow:
Cost of ingredients
$45,000
Salaries expenses
$13,500
Maintenance expenses $1,500
Non cash expenses:
Depreciation
$5,000
Required: Should Rani Beverage Company purchase the new equipment? Use payback method for your
answer.
Solution:
Step 1: In order to compute the payback period of the equipment, we need to workout the net annual
cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the
equipment.
Computation of net annual cash inflow:
$75,000 ($45,000 + $13,500 + $1,500)
= $15,000
Step 2: Now, the amount of investment required to purchase the equipment would be divided by the
amount of net annual cash inflow (computed in step 1) to find the payback period of the equipment.
= $37,500/$15,000
=2.5 years
Depreciation is a non cash expense and therefore has been ignored.
According to payback method, the equipment should be purchased because the payback period of the
equipment is 2.5 years which is shorter than the maximum desired payback period of the company.
Comparison of two or more alternatives choosing from several alternative projects:

Where funds are limited and several alternative projects are being considered, the project with the
shortest payback period is preferred. It is explained with the help of the following example:
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine.
Two types of machines are available in the market machine X and machine Y. Machine X would cost
$18,000 where as machine Y would cost $15,000. Both the machines can reduce annual labor cost by
$3,000.
Required: Which is the best machine to purchase according to payback method?
Solution:
Machine X
Machine Y
Cost of machine (a) $18,000
$15,000
Annual cost saving (b) $3,000
$3,000
Payback period (a)/(b) 6 years
5 years
According to payback method, machine Y is more desirable than machine X because it has a shorter
payback period than machine X.
Payback method and uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow (same cash inflow
during each period) but when projects generate uneven cash inflow (different cash inflow in different
periods), the payback period formula given above cannot be used to compute payback period.
To understand the analysis of a project that generates uneven cash inflow, consider the following
example:
An investment of $200,000 is expected to generate the following cash flows in six years:
Year Net cash flow
1
$30,000
2
$40,000
3
$60,000
4
$70,000
5
$55,000
Required: Compute payback period of the investment. Should the investment be made if management
wants to recover the initial investment in 3 years or less?
Solution:
(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the
payback period. We can compute the payback period by computing the cumulative net cash flow as
follows:
Year Net cash flow Cumulative net cash inflow
1
$30,000
$30,000
2
$40,000
$70,000
3
$60,000
$130,000
4
$70,000
$200,000
5
$55,000
$255,000
6
$45,000
$300,000
Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal to initial
amount of investment.
(2). As the payback period is longer than the maximum desired payback period of the management (3
years), the investment should not be made
Advantages and Disadvantages
Advantages of payback period are:
1. Payback period is very simple to calculate.

2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are
considered more uncertain, payback period provides an indication of how certain the project cash
inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that would return money
early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a serious drawback since it
can lead to wrong decisions. A variation of payback method that attempts to remove this drawback is
called discounted payback period method.
2.It does not take into account, the cash flows that occur after the payback period.

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PAYBACK PERIOD

CHRISTINE NYANDAT, 19 Nov, 2013

Example 2: Uneven Cash Flows

Comparison of two or more alternatives choosing from several alternative projects:

Payback method and uneven cash flow:

Advantages and Disadvantages

Advantages of payback period are:

1. Payback period is very simple to calculate.

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