Lesson 1, Topic 1
In Progress

Payback


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The payback period is usually expressed in years, which it takes the cash inflows from a capital investment project to equal the cash outflows. The method recognizes the recovery of original capital invested in a project. At payback period the cash inflows from a project will be equal to the project’s cash outflows.

This method specifies the recovery time, by accumulation of the cash inflows (inclusive of depreciation) year by year until the cash inflows equal to the amount of the original investment. The length of time this process takes gives the ‘pay-back period’ for the project. In simple terms it can be defined as the number of years required to recover the cost of the investment.

In case of capital rationing situations, a company is compelled to invest in projects having shortest payback period. When deciding between two or more competing projects the usual decision is to accept the one with the shortest payback.

Payback is commonly used as a first screening method. It is a rough measure of liquidity and rate of profitability. This method is simple to understand and easy to apply and it is used as an initial screening technique. This method recognizes the recovery of the original capital invested in a project.

Merits:

(a) It is simple to apply, easy to understand and of particular importance to business which lack the appropriate skills necessary for more sophisticated techniques.

(b) In case of capital rationing, a company is compelled to invest in projects having shortest payback period.

(c) This method is most suitable when the future is very uncertain. The shorter the payback period, the less risky is the project. Therefore, it can be considered as an indicator of risk.

(d) This method gives an indication to the prospective investors specifying when their funds are likely to be repaid.

(f) Ranking projects according to their ability to repay quickly may be useful to firms when experiencing liquidity constraints. They will need to exercise careful control over cash requirements.

(e) It does not involve assumptions about future interest rates.

Demerits:

(a) It does not indicate whether an investment should be accepted or rejected, unless the payback period is compared with an arbitrary managerial target.

(b) The method ignores cash generation beyond the payback period and this can be seen more a measure of liquidity than of profitability.

(c) It fails to consider the timing of returns and the cost of capital. It fails to consider the whole life time of a project. It is based on a negative approach and gives reduced importance to the going concern concept and stresses on the return of capital invested rather than on the profits occurring from the venture.

(d) The traditional payback approach does not consider the salvage value of an investment. It fails to determine the payback period required in order to recover the initial outlay if things go wrong. The bailout payback method concentrates on this abandonment alternative.

(e) This method makes no attempt to measure a percentage return on the capital invested and is often used in conjunction with other methods.

(f) The projects with long payback periods are characteristically those involved in long-term planning, and which determine an enterprise’s future. However, they may not yield their highest returns for a number of years and the result is that the payback method is biased against the very investments that are most important to long-term.

Payback period formula – even cash flow:

When net annual cash inflow is even (i.e., same cash flow every period), the payback period of the project can be computed by applying the simple formula given below:

The denominator of the formula becomes incremental cash flow if an old asset (e.g., machine or equipment) is replaced by a new one.

Payback method with uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow, but many projects usually generate uneven cash flow. When projects generate inconsistent or uneven cash inflow (different cash inflow in different periods), the simple formula given above cannot be used to compute payback period. In such situations, we need to compute the cumulative cash inflow and then apply the following formula:

SELF-CHECK ACTIVITY

1. What is payback method?

2. State the merit and demerit of payback?

3. Discuss payback in even and uneven cash flow?