Question

While NPV and IRR are measures of return of a project/investment. Payback is a measure of risk. Explain what payback tells about a project/investment and how is it calculated.

Answer 1

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.

Formula

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/C

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.

Decision Rule

Accept the project only if its payback period is LESS than the target payback period.

Thanks