Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is:
|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 formula for payback period:
|Payback Period = A +||B|
In the above formula,
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.
Accept the project only if its payback period is LESS than the target payback period.
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.
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.
|(cash flows in millions)||Cumulative|
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
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 remove this drawback is called discounted payback period method.
- It does not take into account, the cash flows that occur after the payback period.