Payback Period – Capital Budgeting Evaluation Techniques
[Watch video for detailed explanation of concept, formula with examples]
Capital budgeting evaluation techniques are divided into two based on whether or not considering time value of money. If it ignores time value of money, they are non-discounted cash flow type and if it considers time value of money, they are discounted cash flow type.
One example of non-discounted cash flow type of capital budgeting techniques.
Payback Period (PBP)
Payback period is the time at which the investor has recovered the money invested in the project. That is the expected number of periods (years) required to recover a project’s cost.
Methods to calculate Payback Period
1. For uniform cash inflow
Here the annual cash inflows are same for every year. For example, if an investment of Rs. 100000 in a project is expected to generate cash inflow of Rs. 25000 pa for 5 years. In these types of cases payback period can be calculated by the formula:
[Watch video for solution of the example given above]
2. For non-uniform cash flows
In non-uniform cash flows, the cash inflows are not same for every year. For an example, the initial investment in a project is Rs. 100000 and the annual cash inflows for next 5 years are Rs. 25000, Rs. 28000, Rs. 30000, Rs. 35000 and Rs. 38000. Here you can see the cash inflows are not same for every year.
In such types, we take cumulative cash flows after tax until the total equals the capital investment.
[Watch video for solution for example given above]
Decision Rule
Accept the project if the payback period is less than the maximum acceptable payback period.
Reject the project if the payback period is greater than the maximum acceptable payback period.
Advantages of Payback Period
1. It is simple, easy and cost effective
2. It is easy to understand the project easily
3. Payback period can be considered as an estimate of risk.
4. Since the selection of project in this method is based on early recovery of the investment, the project with more cash inflows in early years will be selected. So more liquid projects are selected. Thus it is useful for the firms suffering from a liquidity crisis.
Disadvantages of Payback Period
1. It is not considering time value of money.
2. It ignores cash flows beyond payback period.
3. It may lead to ignore long term projects which can lead to competitive advantage to organization.
4. There is no logic base to decide standard payback period of the organization.
Payback Reciprocal
Here we are going to study one more term related to payback period, which is payback reciprocal. As the name suggests, it is the reciprocal of payback period.
The payback reciprocal can be calculated as follows:
For example, consider an investment with initial investment of Rs. 100000 and the expected cash inflow is Rs. 25000 pa for 10 years.
[Watch video for solution of this example]
The payback reciprocal is considered as a good approximation of IRR (internal rate of return) under two approximations.
i) The life of the project is too large or at least twice the payback period.
ii) The project generates constant annual cash inflow.