Question

Explain the concept of Payback Period (PP) in capital budgeting, and how it is computed. What is the payback period of a project with the following cashflows (at time periods 0, 1, 2 and 3): -$50,000, $30,000, $15,000, $15,000? Under what circumstances would PP be preferred to the Net Present Value (NPV) approach. (maximum length guide: about 150 words)

Answer 1

The Pay back period is one of the method of taking a capital budgeting decision whereby we calculate the time taken by project inflows to cover the capital outflow cost.Pay back period ignores the time value of money because it takes nominal cash flows instead of discounting cash flows. Also this ignores the amount of extra cash flow/profit which is arising from investing in the project

It is computed as Initial investment/Annual cash inflows where the cash flows are equal.

Where the cash flows are unequal the payback period will be calculated as follows:

Year Cash flows Cumulative cash inflows

0 (50000) -50000

1 30000 -20000

2 15000 -5000

3 15000 10000

The cumulative cash inflows becomes positive after 2 years so the payback period will be between the 2 & 3 years.

The formula is Completed years + (Cash flow required to become cumulative cash flow 0/Next year cash flow)

2 + (5000/15000) = 2.33 years

The pay back period is generally prefereable only when the company have other opportunities in the near future becasue this method is not very much prefereable except in rare circumstances.