Payback Period Definition
The payback period is the number of years to recover the initial investment if the cash flows depict an annuity pattern. Payback period formula uneven cash flows is one of the most straightforward investment appraisal techniques.
The two methods involved in the investment appraisal technique include the non-discounted and discounted cash flow techniques. The payback period is under the non-discounted cash flow technique.
Features of Capital Appraisal Technique
- Should consider the time value of money by discounting cash flows.
- Must be able to give decision criteria for accepting or rejecting a project.
- Must use cash flows rather than accounting profits to evaluate the project.
- Should be flexible and applicable to all projects.
How the Payback Period Works?
Investors and companies use the payback period to evaluate investment returns and risk. It is usually expressed in years; the fewer the years, the more desirable the project. Conversely, the longer the payback period, the less attractive the investment. Businesses also use it to calculate the rate of return on newly upgraded assets and technology.
Payback Period Formula Even Cash Flows
If cash flow has an annuity pattern, the formula used is given as follows:
| Payback period = Initial Investment ÷ Annuity Cash Inflow |
An example of such an event is shown below.
A project has an initial investment of 150,000. It promises the following cash flow
| YEAR | CASH FLOW |
| 1 | 40,000 |
| 2 | 40,000 |
| 3 | 40,000 |
| 4 | 40,000 |
Payback Period = 150,000 ÷ 40,000
PP = 3 years 9 months
Payback Period Formula Uneven Cash Flows
If the cash flow does not have an annuity pattern, the formula used is as follows:
| PP = Years before Full Recovery + Cash Balance to Payback ÷ Cash Inflow in Breakeven Year |
An example of such an event is shown below
A project has an initial outlay of 150,000, and it promises the following cash flows.
| YEAR | CASH FLOW |
| 1 | 100,000 |
| 2 | 60,000 |
| 3 | 50,000 |
| 4 | 40,000 |
Determine the payback period of the project
| Payback period= 1 + [(150,000 – 100,000) ÷ 60000] |
Payback Period = 1 year 9 months
Assumptions of Payback Period
The core assumption of the payback period is that the return on investment continues after the payback period. It is false because it does not specify any required comparison to the other investments.
Decision Rule in Payback Period
The payback decision rule states that management should accept a project if it exceeds the target payback period. If the project is independent, then the management should accept a project whose payback period is less than the acceptable payback period.
The management should only accept projects whose payback period is within the acceptable payback period.
If the projects are mutually exclusive, then the management should accept the project with the lowest payback period and reject all the other projects.
