Payback Analysis
Under payback method, an investment project is accepted or rejected on the basis of payback
period. Payback period means the period of time that a project requires recovering the money
invested in it. It is mostly expressed in years. Payback method does not take into account the
time value of money.
According to payback method, the project that promises a quick recovery of initial investment is
considered desirable. If the payback period of a project is shorter than or equal to the
management’s maximum desired payback period, the project is accepted, otherwise rejected. For
example, if a company wants to recover the cost of a machine within 5 years of purchase, the
maximum desired payback period of the company would be 5 years. The purchase of machine
would be desirable if it promises a payback period of 5 years or less.
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:
Example-1
The Delta Company is planning to purchase a machine known as machine X. Machine X would
cost $25,000 and the useful life of the machine is 10 years. The expected annual cash inflow of
the machine is $10,000.
Required: Compute payback period of machine X and conclude whether or not the machine
would be purchased if the maximum desired payback period of Delta Company is 3 years.
Solution
Since the annual cash inflow is even in this project, we can simply divide the initial investment
by the annual cash inflow to compute the payback period. It is shown below:
Payback period = $25,000/$10,000
= 2.5 years
According to payback period analysis, the purchase of machine X is desirable because it’s
payback period is 2.5 years which is shorter than the maximum payback period of the company.
Example-2
Due to increased demand, the management of Rani Beverage Company is considering to
purchase a new equipment to increase the production and revenues. The useful life of the
equipment is 10 years and the company’s maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:
Initial cost of equipment: $37,500
Annual cash inflows:
Sales: $75,000
Annual cash Outflows:
Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
Required: Should Rani Beverage Company purchase the new equipment? Use payback method
for your answer.
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Solution
Step 1: In order to compute the payback period of the equipment, we need to work out the net
annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated
with the equipment.
Computation of net annual cash inflow: $75,000 – ($45,000 + $13,500 + $1,500) = $15,000
Step 2: Now, the amount of investment required to purchase the equipment would be divided by
the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.
= $37,500/$15,000
=2.5 years
According to payback method, the equipment should be purchased because the payback period
of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4
years.
Comparison of Two or More Alternatives – Choosing from Several
Alternative Projects
Where funds are limited and several alternative projects are being considered, the project with
the shortest payback period is preferred. It is explained with the help of the following example:
Example-3
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new
machine. Two types of machines are available in the market – machine X and machine Y.
Machine X would cost $18,000 whereas machine Y would cost $15,000. Both the machines can
reduce annual labor cost by $3,000.
Required: Which is the best machine to purchase according to payback method?
Solution
Payback period of machine X: $18,000/$3,000 = 6 years
Payback period of machine y: $15,000/$3,000 = 5 years
According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.
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:
Example 4
An investment of $200,000 is expected to generate the following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?
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Solution
Because the cash inflow is uneven, the payback period formula of even cash inflow cannot be
used to compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:
Payback Period = 3 + (15,000/40,000)
= 3 + 0.375
= 3.375 Years
Unrecovered investment at start of 4th year:
= Initial cost – Cumulative cash inflow at the end of 3rd year
= $200,000 – $185,000
= $15,000
The payback period for this project is 3.375 years which is longer than the maximum desired
payback period of the management (3 years). The investment in this project is therefore not
desirable.
Advantages and Disadvantages of Payback Method
Some advantages and disadvantages of payback method are given below:
Advantages
1. An investment project with a short payback period promises the quick inflow of cash. It
is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the business
quickly. The payback period is important for the firms for which liquidity is very
important.
3. An investment with short payback period makes the funds available soon to invest in
another project.
4. A short payback period reduces the risk of loss caused by changing economic conditions
and other unavoidable reasons.
5. Payback period is very easy to compute.
Disadvantages
1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback period.
For example, two projects, project A and project B require an initial investment of
$5,000. Project A generates an annual cash inflow of $1,000 for 5 years whereas project
B generates a cash inflow of $1,000 for 7 years. It is clear that the project B is more
profitable than project A. But according to payback method, both the projects are equally
desirable because both have a payback period of 5 years ($5,000/$1,000).
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