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Payback Period

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Financial Accounting Managerial Accounting

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash

Corporate Finance

inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Current Chapter

Formula The formula to calculate payback period of a project depends on whether the cash flow per period from the

Capital Budgeting Hurdle Rate

project is even or uneven. In case they are even, the

Mutually Exclusive Projects

formula to calculate payback period is:

Projects with Uequal Lives Sunk vs Opportunity Costs Incremental Cash Flows Payback Period Discounted Payback Period

Payback Period =

Initial Investment Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following

Accounting Rate of Return Net Present Value NPV and Inflation NPV and Taxes Internal Rate of Return

formula for payback period:

Multiple IRRs Payback Period = A +

B

NPV vs IRR

C

Profitability Index Adjusted Present Value

In the above formula,

Asset Replacement Decision

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)

Cumulative

Year

Cash Flow

Cash Flow

0

(50)

(50)

1

10

(40)

2

13

(27)

3

16

(11)

4

19

8

5

22

30

Payback Period = 3 + (|-$11M| ÷ $19M) = 3 + ($11M ÷ $19M) » 3 + 0.58 » 3.58 years

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. Written by Irfanullah Jan Tweet

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Related Topics Discounted Payback Period Net Present Value Adjusted Present Value Internal Rate of Return Accounting Rate of Return Profitability Index

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