Payback period is one of the methods of investment appraisal. It refers to the number of periods or years that a project will take to recover the initial cash outlay invested in a project. This technique applies cash flows and not accounting profits. If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:
Example 7.1: Calculating Payback Period with Constant Cash Flows
Assume that a project requires an outlay of $200,000 and yields annual cash inflow of $40,000 for 9 years. The payback period for the project is:
PB = $200,000/40,000 = 5 years.
Example 7.2: Calculating Payback Period with Uneven Cash Flows
Suppose that a project requires a cash outlay of $20,000, and generates cash inflows of $8,000; $7,000; $4,000; and $3,000 during the next 4 years. What is the project’s payback?
Solution:
Add annual cash inflows
8,000 + 7,000 + 4,000 + 3,000 = 22,000
The total cash inflows of $22,000 exceeds the initial cash outflow of $20,000. To get the payback period, try adding the cash inflows first three years:
8,000 + 7,000 + 4,000 = 19,000
The total cash inflows for three years is less than the initial cash outlay. This means that the payback period lies between three and four years. The remaining amount to recover the initial invested amount is:
$20,000 – $19,000 = $1,000
Assuming that the cash inflow is even throughout the fourth year, the time required to recover the remaining $1,000 is:
(1,000/3,000) 12 months = 4 months.
Thus, the payback period is 3 years and 4 months.
Example 7.3: Comparing two projects
Porojo Company Ltd, a medium sized agricultural company that is currently contemplating two projects: project A requires an initial investment of $42 million and project B requires an initial investment of $45 million. The projected relevant cash flows for the two projects are shown below:
Project A | Project B | |
Initial Investment | $42 million | $45 million |
Annual Cash Inflows | ||
Year 1 | $14 million | $28 million |
Year 2 | $14 million | $12 million |
Year 3 | $14 million | $10 million |
Year 4 | $14 million | $10 million |
Year 5 | $14 million | $10 million |
Average | $14 million | $14 million |
For project A, the Payback period is straightforward because it has a constant cash flow for all the five years:
Payback Period = 42/14 = 3 years.
For Project B, we have to add up cumulative amounts for each year to determine the payback period.
Year | Annual Cash Flows | Cumulative |
Year 1 | $28 million | $28 million |
Year 2 | $12 million | $40 million |
Year 3 | $10 million | $50 million |
Year 4 | $10 million | $60 million |
Year 5 | $10 million | $70 million |
On the cumulative column in the table above, you are adding the cash flows for each year so that you can know which year the initial cash outlay is recovered. For example, in the second row you add first year cash flows to the cash flows of the second year to get $40 million. When you add $10 million for the third year you get $50,000, which is higher than the initial cash outlay of $45 million. Therefore, the payback period is between the second and the third year.
Payback period = 2 + [(45-40)/10] = 2+0.5 = 2.5 years/ 2 years and six months.
Only 50% of year 3 cash inflows of Sh.10million are needed to complete the payback period of the initial investment ofSh.45million. Therefore payback period of project B is 2.5 years.
Decision criteria:
- If the maximum acceptable Payback period for the company was 2.75 years, Project A would be rejected and project B would be accepted.
- If projects were being ranked, Project B would still be preferred because it recovers the project’s initial investment faster than project A.
- Where the projects are independent the project with the lowest PBP should rank as the first as the initial outlay is recouped within a shorter time period.
- For mutually exclusive projects, the project with the lowest PBP should be accepted.