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Capital Budgeting is one of the main functions in finance management. This uses various techniques to assist management in selecting one project over another. During the course of business, the management comes across various opportunities that lead to the expansion of existing projects or new projects. Ideally, management would not like to forgo any good opportunity but due to capital restraints, it has to choose between projects. One of the techniques to implement capital budgeting is using the ‘payback period.’

What is the meaning of payback period?

Payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project.  Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected.  

Salient features of Payback period method

  • Payback period is a simple calculation of time for the initial investment to return.
  • It ignores the time value of money.  All other techniques of capital budgeting consider the concept of time value of money. Time value of money means that a rupee today is more valuable than a rupee tomorrow. So other techniques discount the future inflows and arrive at discounted flows.
  • It is used in combination with other techniques of capital budgeting. Owing to its simplicity the payback period cannot be the only technique used for deciding the project to be selected.  

Illustrations

Let us understand the payback period method with a few illustrations.

Apple Limited has two project options.  The initial investment in both the projects is Rs.  10,00,000.

Project A has even inflow of Rs. 1,00,000 every year.  

Project B has uneven cash flows as follows:

Year 1 – Rs.  2,00,000

Year 2 – Rs.  3,00,000

Year 3 – Rs.  4,00,000

Year 4 – Rs.  1,00,000

Now let us apply the payback period method to both the projects.  

The formula for computing payback period with even cashflows is:

Pay back period =

Total outflows                                                  Initial investment 

__________                  or                 _______________

Inflow every year                                      Net annual cash inflows

Project A

If we use the formula, Initial investment / Net annual cash inflows then:

10,00,000/ 1,00,000 = 10 years

Project B

Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000)

Total outflows = 10,00,000

Project B takes four years to get back the initial investment.

Now, let us modify the cash flows of project B and see how to get the payback period:

Say, cash inflows are –

Year 1 – Rs.  2,00,000

Year 2 – Rs.  3,00,000

Year 3 – Rs.  7,00,000

Year 4 – Rs.  1,50,000

The payback period can be calculated as follows:

Year Total flow ( in Lakhs) Cumulative flow
0 (10) (10)
1 2 (8)
2 3 (5)
3 7 2
4 1.5 3.5

Now to find out the payback period:

Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two.

Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.

So that is: 5/7 = 0.71

Step 3: Step 1 + Step 2 = The payback period is 2.71 years.

Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected.  

The example stated above is a very simple presentation. In an actual scenario, an investment might not generate returns for the first few years. Gradually over time, it might generate returns. That too will play a major role in determining the payback period.

Note: In case an organization is replacing an existing machinery, the inflows will be considered on an incremental basis.  

What are the shortcomings of this method?

This method does not take into account the time value of money and treats all flows at par. For example, Rs.1,00,000 invested yearly to make an investment of Rs.10,00,000 over a period of 10 years may seem profitable today but the same 1,00,000 will not hold the same value ten years later. Also, the method does not take into account the cash flows post the return of investment. Some projects may generate higher cash flows in the later life of the project.

Despite its drawbacks, payback method is the simplest method to analyze different project/investments. It is based on the principle of liquidity. The project that provides a faster return of investment is chosen. More liquidity means more availability of funds to invest in more projects. It is used by the management to get a quick analysis of the project. Payback method is used by individuals also to analyze investment decisions. It is based on a very simple need to get back at least how much has been spent. In fact, even as individuals when we invest in shares, mutual funds our first question is always about the time period within which we will get back our invested money.  So, it is simple and very easy to understand.

 

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