Question

Payback Method

The management of Deitrich Inc., a civil engineering design company, is considering an investment in a high-quality blueprint printer with the following cash flows:

Year               Investment   Cash Inflow

1                    $28,000          $2,000

2                      $4,000          $3,000

3                                            $6,000

4                                            $8,000

5                                            $9,000

6                                            $8,000

7                                            $6,000

8                                            $5,000

9                                            $4,000

10                                            $4,000

Required:

Determine the payback period of the investment.

Would the payback period be affected if the cash inflow in the last year was several times larger?

Answer 1

Formula sheet

A

B

C

D

E

F

G

H

I

J

K

L

M

N

O

2

3

Calculation of Payback period:

4

Payback period is the period when investment amount is recovered.

5

Year

0

=D5+1

=E5+1

=F5+1

=G5+1

=H5+1

=I5+1

=J5+1

=K5+1

=L5+1

=M5+1

6

Investment

-28000

-4000

7

Cash Inflow

2000

3000

6000

8000

9000

8000

6000

5000

4000

4000

8

Free Cash Flow

=E6+E7

=F6+F7

=G6+G7

=H6+H7

=I6+I7

=J6+J7

=K6+K7

=L6+L7

=M6+M7

=N6+N7

9

Cumulative cash flow

=D9+E8

=E9+F8

=F9+G8

=G9+H8

=H9+I8

=I9+J8

=J9+K8

=K9+L8

=L9+M8

=M9+N8

10

11

Payback period is when cumulative free cash flow becomes zero.

12

It can be seen from above that cumulative cash flow becomes zero between year 5 and year 6.

13

14

To estimate the exact payback period cumulative free cash flow can be proprated over the years as follows:

15

Payback period

=I5+(0-I9)/(J9-I9)

=I5+(0-I7)/(J7-I7)

16

17

Hence Payback period is

=D15

Years

18

19

Increasing the cash flow in the last year will not affect the payback period as cumulative cash flow is already zero between year 5 & 6.

20