What is Payback Period?
Payback Period is the time where a project’s net cash inflows are equal to the project’s initial cash investment. This method is often used as the initial screen process and helps to determine the length of time required to recover the initial cash outlay (investment) in the project.
Payback period is defined by CIMA as, ” The time required for the cash inflows from a capital investment project to equal the initial cash outflows.”
Usually, Organization’s must have a targeted payback period. If a payback period is larger than
The formula of Payback Period are :
Payback period = Initial Outlay / Net Cash inflows
Accept/ Rejects Criteria: The Project which has a lesser payback period will be accepted.
The main advantages of payback period are as follows:
- A longer payback period indicates capital is tied up.
- Focus on early payback can enhance liquidity
- Investment risk can be assessed through payback method
- Shorter term forecasts
- This is more reliable technique
- The calculation process is quicker than and simple than any other appraisal techniques
- This is a very easily understood concept
Disadvantages of Payback Period Method
There are numbers of serious drawbacks to the payback Period Method:
- It ignores the timing of cash inflows within the payback period
- It ignores the cash flow produced after the end of the payback period and therefore the total return of the project.
- It ignores the time value of money
It influence forexcessive investment in short termprojects.
A Machine costing $ 240,000 is to be depreciated over ten years to a nil residual value. The profits after depreciation for the first 5 years are as follows:
|Year||Profits after Depreciation|
Calculate Payback period to the nearest months.
|Year||Profit after depreciation||Depreciation||Cash flow ($)||Cumulative Cash Flow ($)|
Payback Period = 4 years + (275,000 – 233,000)/73,000 * 12 months = 4.7 years.