Payback Period Method

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This is the most popular non discounted cash flow capital budgeting techniques which is simplest to calculate & gives the answer to very first question asked by most of the stakeholders i.e. In how many years, invested amount will be recovered? In other words, the Payback period is the number of years required to recover the original investment in the project. Hence it is the number of years in which cumulative cash inflows equals the cash outflow.

Relevant Facts
a. The Payback period doesn’t have decision rule like NPV (Net Present Value) & IRR (internal Rate of Return). This is just a liquidity measure. 
b. Acceptance or rejection of the proposal totally depends on the specified timeframe in which company / individual wants their money back. 
c. Payback period should not be used alone. It should be used alongside any one of the DCF (Discounted cash flow) techniques i.e. NPV (Net Present Value) or IRR (Internal Rate of Return).

How to calculate Payback Period?
Suppose, Initial cash outflow is $90,000 for two projects i.e. A & B
Cash inflows for subsequent years are mentioned below.
Calculate the cumulative cash inflow in a separate column & calculate it till the last inflow. Mark a year in which you find your initial investment is recovered.

Hence, it is clear from the table that
a. Payback period for Project A is 7 Years, Total cash inflow is $1,35,000
b. Payback period for Project B is 4 Years, Total cash inflow is $1,00,000

Now the question arises, which project to choose? Most of the people who prefer Payback Period method would suggest Project B but Project A can’t be ignored due to surplus cash inflow of $35,000 ($1, 35,000 - $1, 00,000). Hence it is suggested that one should use Payback Period method in combination of DCF methods and base their judgement by evaluating all aspects.

Advantages of Payback period method
1. It’s easy & simple to calculate.
2. It measures the liquidity aspect of the proposal. The project with Payback period of 3 years can be considered more liquid as compared to project with Payback period of 5 years.

Disadvantages of Payback period method
1. It ignores many cash inflows which happen after payback period. Hence, the projects which tend to generate larger cash inflow at later years get discriminated.
2. It ignores the salvage value & total economic life of the project.
3. Most importantly, it ignores the time value of money.
4. It doesn't account for the profitability figure out of a project. Long term profitability should not be ignored during selection of project.

1 comment :

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