Unlike net present value method and internal rate of return method, payback method does not consider the present value of cash flows. Under this method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. The payback period of a project is expressed in years and is computed using the following formula:

Formula of payback period:

payback-period-formula

According to this method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project computed by the above formula is shorter than or equal to the management’s maximum desired payback period, the project is accepted otherwise it is rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less.

Consider the following example to understand the analysis of a project under this method:

Example 1:

Due to increased demand, the management of Rani Beverage Company is considering to purchase a new equipment to increase the production and revenues. The useful life of the equipment is 10 years and the company’s maximum desired payback period is 4 years.  The inflow and outflow of cash associated with the new equipment is given below:

The initial cost of equipment $37,500
Annual cash inflow:
Sales $75,000
Annual cash outflow:
Cost of ingredients $45,000
Salaries expenses $13,500
Maintenance expenses $1,500
Non cash expenses:
Depreciation $5,000

Required: Should Rani Beverage Company purchase the new equipment? Use payback method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)
= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be divided by the amount of net annual cash inflow (computed in step 1) to find the payback period of the equipment.

payback-period-formula

= $37,500/$15,000

=2.5 years

Depreciation is a non cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of the company.

Comparison of two or more alternatives – choosing from several alternative projects:

Where funds are limited and several alternative projects are being considered, the project with the shortest payback period is preferred. It is explained with the help of the following example:

Example 2:

The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine. Two types of machines are available in the market – machine X and machine Y. Machine X would cost $18,000 where as machine Y would cost $15,000. Both the machines can reduce annual labor cost by $3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Machine X Machine Y
Cost of machine (a) $18,000 $15,000
Annual cost saving (b) $3,000 $3,000
Payback period (a)/(b) 6 years 5 years

According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X.

Payback method and uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow (same cash inflow during each period) but when projects generate uneven cash inflow (different cash inflow in different periods), the payback period formula given above cannot be used to compute payback period.

To understand the analysis of a project that generates uneven cash inflow, consider the following example:

Example 3:

An investment of $200,000 is expected to generate the following cash flows in six years:

Year Net cash flow
1 $30,000
2 $40,000
3 $60,000
4 $70,000
5 $55,000
6 $45,000

Required: Compute payback period of the investment. Should the investment be made if management wants to recover the initial investment in 3 years or less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period. We can compute the payback period by computing the cumulative net cash flow as follows:

Year Net cash flow Cumulative net cash inflow
1 $30,000 $30,000
2 $40,000 $70,000
3 $60,000 $130,000
4 $70,000 $200,000
5 $55,000 $255,000
6 $45,000 $300,000

Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal to initial amount of investment.

(2). As the payback period is longer than the maximum desired payback period of the management (3 years), the investment should not be made.

Advantages and disadvantages of payback method:

Advantages:

  1. An investment project with a short payback period promises the quick inflow of cash. It is therefore, a useful capital budgeting method for cash poor firms.
  2. A project with short payback period can improve the liquidity position of the business quickly. The payback period is important for the firms for which liquidity is very important.
  3. An investment with short payback period makes the funds available soon to invest in another project.
  4. A short payback period reduces the risk of loss caused by changing economic conditions and other unavoidable reasons.
  5. Payback period is very easy to compute.

Disadvantages:

  1. The payback method does not take into account the time value of money.
  2. It does not consider the useful life of the assets and inflow of cash after payback period. For example, If two projects, project A and project B require an initial investment of $5,000. Project A generates an annual cash inflow of $1,000 for 5 years whereas project B generates a cash inflow of $1,000 for 7 years. It is clear that the project B is more profitable than project A. But according to payback method, both the projects are equally desirable because both have a payback period of 5 years ($5,000/$1,000).