Question

Payback Period

An organization’s initial outlay for a proposed project is $650,000. Use the table below to calculate the payback period for this project.

Free Cash Flows
Year	Amount		Year	Amount
1	$95,000.00		6	$620,000.00
2	$46,000.00		7	$100,000.00
3	$167,000.00		8	$100,000.00
4	$185,000.00		9	$100,000.00
5	$90,000.00		10	$100,000.00

The organization’s objectives indicate a corporate payback period of 7 years or less.

Would the company be able to meet the cost of the project according to its stated payback period goal? Why or why not? Why is it important for an organization to recover its investing capital in the shortest period of time?

Answer 1

Payback Period for the Project

Year	Cash Flows ($)	Cumulative net Cash flow ($)
0	-6,50,000.00	-6,50,000.00
1	95,000.00	-5,55,000.00
2	46,000.00	-5,09,000.00
3	1,67,000.00	-3,42,000.00
4	1,85,000.00	-1,57,000.00
5	90,000.00	-67,000.00
6	6,20,000.00	5,53,000.00
7	1,00,000.00	6,53,000.00
8	1,00,000.00	7,53,000.00
9	1,00,000.00	8,53,000.00
10	1,00,000.00	9,53,000.00

Payback Period = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 5 Year + ($67,000 / $620,000)

= 5 Year + 0.11 years

= 5.11 Years

“The Payback Period for the Project = 5.11 Years”

The Project should be accepted, Since, Payback Period of 5.11 Years is less than the Maximum allowable payback period of 7 years, Therefore, it is an acceptable project

Payback Period Method in Capital Budgeting

- The Payback Period Method refers to the period in which the proposed project will generate the cash inflows to recover the Initial Investment costs. In Capital Budgeting Method, The Payback Period method does not use the concept of Time Value of money. It considers only three components such as Initial Investment costs, Economic life of the project and the annual cash inflows

- Payback period is the number of years taken to recover the total amount of money invested in the project. If the payback period is less than the enterprises required number of years, then the project should be accepted, Else it is rejected. In the Discounted Payback Period Approach, it considers the concept of time value of money