payback period.pptx

7/28/2019 Payback Period.pptx

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Payback Period

Time period required to recover the costof the investment from the annualcash inflow produced by the

investment.

Amount investedExpected annual net cash inflow


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The Payback Period

Number of years needed to recover theinitial cash outlay of project.

Decision Rule: Project desirable if the

payback period is the firms maximumpayback period.

Shorter payback period is preferred whencomparing two projects.


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Cash Payback Period

5 years$130,000 $26,000/ =


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Casey Co. wantsto install a

machine thatcosts $16,000 andhas an 8-yearuseful life with

zero salvagevalue. Annual netcash flows are:

Year

Annual Net

Cash Flows

Cumulative

Net Cash

Flows

0 (16,000)$ (16,000)$1 3,000 (13,000)

2 4,000 (9,000)

3 4,000 (5,000)

4 4,000 (1,000)

5 5,000

6 3,000

7 2,000

8 2,000

Payback PeriodUneven Cash Flows


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Year

Annual Net

Cash Flows

Cumulative

Net Cash

Flows

0 (16,000)$ (16,000)$1 3,000 (13,000)

2 4,000 (9,000)

3 4,000 (5,000)

4 4,000 (1,000)

5 5,000

6 3,000

7 2,000

8 2,000

4.2

Payback PeriodUneven Cash Flows

We recover the $16,000purchase price between

years 4 and 5, about4.2 years for thepayback period.


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Using the Payback Period

Consider two projects, each with a 5-year lifeand each costing $6,000.

Project One Project Two

Net Cash Net CashYear Inflows Inflows

1 2,000$ 1,000$

2 2,000 1,000

3 2,000 1,000

4 2,000 1,000

5 2,000 1,000,000

Would you invest in Project One just because

it has a shorter payback period?

Payback = 3 years Payback = 5 years


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6.2 The Payback Period Rule

How long does it take the project topay back its initial investment?

Payback Period = number of years to

recover initial costs Minimum Acceptance Criteria:

set by management

Ranking Criteria: set by management


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The Payback Period Rule(continued) Disadvantages:

Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the paybackcriteria may not have a positive NPV

Advantages: Easy to understand

Biased toward liquidity


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Payback Period

The payback method simply measureshow long (in years and/or months) it takesto recover the initial investment.

The maximum acceptable payback period

is determined by management. If the payback period is less than the

maximum acceptable payback period,accept the project.

If the payback period is greater than themaximum acceptable payback period,reject the project.


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Pros and Cons of PaybackPeriods The payback method is widely used by

large firms to evaluate small projects andby small firms to evaluate most projects.

It is simple, intuitive, and considers cashflows rather than accounting profits.

It also gives implicit consideration to thetiming of cash flows and is widely used as a

supplement to other methods such as NetPresent Value and Internal Rate of Return.


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Pros and Consof Payback Periods (cont.)

One major weakness of the paybackmethod is that the appropriate paybackperiod is a subjectively determined number.

It also fails to consider the principle ofwealth maximization because it is notbased on discounted cash flows and thusprovides no indication as to whether aproject adds to firm value.

Thus, payback fails to fully consider thetime value of money.


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Payback Period Example

Ex: Project with an initial cash outlay of $20,000 with following free cashflows for 5 years.

Payback is 4 years.

YEAR CASH FLOW BALANCE1 $ 8,000 ($ 12,000)

2 4,000 ( 8,000)

3 3,000 ( 5,000)

4 5,000 05 10,000 10,000


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Payback period

Benefits: Uses cash flows rather than accounting profits

Easy to compute and understand

Useful for firms that have capital constraints

Drawbacks: Ignores the time value of money

Does not consider cash flows beyond thepayback period.


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Discounted Payback Period

The discounted payback period is similar tothe traditional payback period except that ituses discounted free cash flows.

Discounted payback period: the number ofyears needed to recover the initial cashoutlay from the discounted free cash flows.

payback period.pptx

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