Question

Refer to the textbook, explain how Payback period method and analysis is used in capital budgeting?

Make sure you explain a situation where all cash inflows are equal and where all cash inflows are unequal? Provide a simple example.

When would you accept a project, and when would you reject a project?

Answer 1

In capital budgeting Pay Back period is one of the metods use to take decision of the acceptability or otherwise of a project.

This technique estimates the time required by the project to recover, through cash inflows, the firms initial outlay.

Beginning with the project with the shortest payout period, different projects are arranged in order of time required to recapture their respective estimated initial outlays. The payback period for each investment proposal is compared with the maximum period acceptable to management and proposals are then ranked and selected in order of those having minimum payout period.

While estimating net cash inflows for each investment proposal, the following considerations should be borne in mind:

(i) Cash inflows should be estimated on incremental basis. Cash inflows of current period is taken. Cash flow on cumulative basis is not taken..

(ii) Cash inflows for a project should be estimated on an after-tax basis.

(iii) Since non-cash expenses like depreciation do not involve any cash outflows, estimated cash inflows form a project should be adjusted for such items.

In simple word we can say that cash flow after tax but before Depreciation is taken.

Example:

Initial Investment=25000

Life of project=5 years

Cash inflow Before Depreciation and tax=10000

Tax Rate:50%

Compute Pay back period.

Solution:

Depreciation=5000 i.e. 25000/5

Cash flow after Depreciation=5000 i.e.10000-5000

Cash Flow after Tax=2500 i.e. 5000-50%

Cash inflow after tax but before Depreciation(CFAT)= 7500 i.e.2500+5000

Payback period=Initial investment/CFAT

=25000/7500

=3.3333 Years or 3 years and 4 months.

Now we take an Example of unequal cash flows:

Example:

Initial investment=25000

Annual cash inflows after tax and before Depreciation(i.e. CFAT) are as follows:

Year	Cash inflows
1	6000
2	9000
3	7000
4	6000
5	4000

Solution:

Year	Cash inflows	Cumulative Cash Flows
1	6000	6000
2	9000	15000
3	7000	22000
4	6000	28000
5	4000	32000

It is evident from the table that in 3 years 22000 has been recovered and 3000 is left of initial investment of 25000.

It indicates that payback period is between 3 to 4 years . It is clear that next year 6000 is being recoverd, it takes 1 years to recover 6000 hence for 3000 it will require .5 year.

calculated as follows:

Payback period =Completed years+Required Cash flow/Next year cash flow

=3 years+3000/6000

=3.5Years or 3 years and 6 months.

For accepting a project, the shorter is the payback period, the better it is.

Note: I have taken the help of study material of The Institute of Company Secretaries of India (ICSI) in order to explain the concepts. Some content of this answer can match with that of ICSI Study Material Professional Programme.

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