Payback period is the time in which the initial outlay of an investment is expected to be recovered through the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Since cash flow estimates are quite accurate for periods in the near future and relatively inaccurate for periods in distant future due to economic and operational uncertainties, payback period is an indicator of risk inherent in a project because it takes initial inflows into account and ignores the cash flows after the point at which the initial investment is recovered.
Projects having larger cash inflows in the earlier periods are generally ranked higher when appraised with payback period, compared to similar projects having larger cash inflows in the later periods.
The formula to calculate the payback period of an investment depends on whether the periodic cash inflows from the project are even or uneven.
If the cash inflows are even (such as for investments in annuities), the formula to calculate payback period is:
|Payback Period =||Initial Investment|
|Net Cash Flow per Period|
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:
|Payback Period =||A +||B|
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A
Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.
Both of the above situations are explained through examples given below.
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 in net cash flows for 7 years. Calculate the payback period of the project.
= 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 net cash flow 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.
|Year||(cash flows in millions)|
Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years
The longer the payback period of a project, the higher the risk. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period.
When deciding whether to invest in a project or when comparing projects having different returns, a decision based on payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management.
Management will set an acceptable payback period for individual investments based on whether the management is risk averse or risk taking. This target may be different for different projects because higher risk corresponds with higher return thus longer payback period being acceptable for profitable projects. For lower return projects, management will only accept the project if the risk is low which means payback period must be short.
Advantages and Disadvantages
Advantages of payback period are:
- Payback period is very simple to calculate.
- 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.
- For companies facing liquidity problems, it provides a good ranking of projects that would return money early.
Disadvantages of payback period are:
- 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 address this drawback is called discounted payback period method.
- It does not take into account, the cash flows that occur after the payback period. This means that a project having very good cash inflows but beyond its payback period may be ignored.
by Irfanullah Jan, ACCA and last modified on