The payback method of analysis of capital budgeting method that calculates the amount of time it will take to recoup the investment in a capital asset, with no regard for the time value of money. For example, an investment of $20,000 that will generate annual cash flows of $4,000 has a payback period of five years.
Payback Period
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.
Method To Calculate Payback Period
Payback Period = Cost of Project / Annual Cash Inflows
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 = Last period with a negative cumulative cash flow,
B = Absolute value of cumulative cash flow at the end of the period A,
C = Actual cash flow during the period after A.
Payback period is the the time period needed for the return on an investment to "repay" the sum of the original investment. For example, a $2000 investment which returned $1000 per year would have a two year payback period. The time value of money is not taken into account. All things being equal equal, smaller payback periods are preferable than long term payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below.
Decision Rule
A decision rule is a procedure to decide whether to accept or reject the project .
Example
Ram Singh& Co. is planning to take a project requiring initial investment of $200 million. The project is expected to generate revenue of $50 million per year for 10 years. Calculate the payback period .
Solution
Payback Period = Initial Investment / Annual Cash Flow = $100M / $25M = 4 years
Important Things to be Considered for using payback period
Payback period is an appealing metric because it has an easily understood meaning. Nevertheless, here are some points to keep in mind when using payback period:
Payback Period cannot be calculated if the positive cash inflows do not outweigh the cash outflows. That is why payback period is of little use when used with a pure "costs only" business case or cost of ownership analysis.
There can be more than one payback period for a given cash flow stream. Payback period examples such as the one above typically show cumulative cash flow increasing continuously. In real world cash flow results, however, cumulative cash flow can decrease as well as increase from period to period. When cumulative cash flow is positive in one period, but negative again in the next, there is more than one Payback Period point.
Payback period by itself says nothing about cash flows coming after the payback time. One investment may have a shorter payback period than another, but the latter may go on to greater cumulative cash flow over time.
Payback calculation ordinarily does not recognize the time value of money (in discounting sense) nor does it reflect money coming in after payback (contrast with discounted and internal rate of return, above).
Advantages and Disadvantages Of Payback Period
Advantages
Payback period is simple to calculate.
It can measure of risk in a project. Cash flows that occur later in the life of the project are considered to be uncertain, payback period provides an information or idea of if the project is certain or not.
Companies that are facing problem of liquidity, this method provides ranking of projects with less payback period.
Payback period deals with risk related to the project.
The short-term approach of payback period method is an added advantage.
Disadvantages
Payback period do not take in account the time value of money which is a big drawback because it may lead to wrong decisions. But there is a another form of payback method that remove this drawback and is called discounted payback period method.
This method do not take into account the cash flows that occur after the payback period .
The payback period ignores the salvage value and the project`s total economic life .
The payback period is we can say a method of capital recovery instead a measure of profitability of a project.
The payback period is made to cover the conventional projects that involve large amount of investment followed by positive operating cash inflows. It breaks down when the investment is spread over time or where there is no initial investment.
Calculation of payback period of machines:
Machine1
Machine2
Machine3
Initial investment(a)
Rs.3,00,000
Rs.3,00,000
Rs.3,00,000
Sales(b)
5,00,000
4,00,000
4,50,000
Costs:
Direct material
40,000
50,000
48,000
Direct labour
50,000
30,000
36,000
Factory overhead
60,000
50,000
58,000
Depreciation
1,30,000
91,667
90,000
Administration cost
20,000
10,000
15,000
Selling and Distribution costs
10,000
10,000
10,000
Total cost ©
3,10,000
2,41,667
2,57,000
Profit before tax (b-c)
1,90,000
1,58,333
1,93,000
Less: tax @ 40%
76,000
63,333
77,200
Profit after tax
1,14,000
95,000
1,15,800
Add: depreciation
1,30,000
91,667
90,000
Net cash flow(d)
2,44,000
1,86,667
2,05,800
Payback period (years) (a/d)
1.23
1.61
1.46
Machine 1 has lowest payback period, so it may be preferred over the other two machines.
