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What is Payback Period ? How does it calculate?


Payback Period: It is a tool of capital budgeting which helps to determine, how many periods are required to payout the investment amount to investors or company? With the help of it we can find out which investment is better to fulfil our requirement. Lesser the payback period better will be the investment.
The drawback of payback period is, it does not consider time value of money so, to remove that drawback discounted payback period is used.

Advantages of Payback period:
o   It is very simple to compute.
o   It is easy to understand.
o   It helps in ranking the investment projects.

Disadvantages of Payback period:
o   It ignores time value of money which means it does not show the future retun is how much worth today?.
o   It doesn’t consider the cash flows which occur after the intial investment amount has been received.

Formula for Payback Period:

Payback Period = Cost of Initial Investment/ Net Annual Cash flows

Example: Suppose initial investment is Rs.10, 00,000 and expected future cash flows are as follows:

1.       Rs.4,00,000
2.       Rs.4,00,000
3.       Rs.4,00,000
4.       Rs.4,00,000
5.       Rs.4,00,000
Find out the payback period?

Solution:
Payback Period = Cost of Initial Investment/ Net Annual Cash Flows
= 10, 00,000/4, 00,000
=2.5 years

Example: You invest Rs.7, 00,000 in a project and project will provide future cash flows as follows:

1.       Rs.2,00,000
2.       Rs.3,29,000
3.       Rs.4,52,000
4.       Rs.7,25,000
5.       Rs.8,26,000
Find out the payback period?

Solution:
In above case we have to do the cumulative the future cash flows to determine the payback period.

Year
Cash Flows
Cumulative Cash flows (700,000)
1
2,00,000
(500,000)
2
3,29,000
(171,000)
3
4,52,000
281,000
4
7,25,000
10,06,000
5
8,26,000
18,32,000

= 2+1,71,000/4,52,000
= 2.38 years

Discounted payback period:

It is a technique used to calculate the time required to recover its cost by discounting the present value.  It considers time value of money.

Formula for Discounted Payback Period:

Discounted Payback Period = (A-1) + Cost of investment-Cumulative Cash Flows (A- 1)/Present Value of Cash Flows A

Whereas,
A=year in which cumulative present values exceed from initial investment.
Present Value of Cash Flows A = Present Value in year A

Advantages of Discounted payback period:
o   It is simple to calculate.
o   It consider time value of money.

Disadvantages of Discounted payback period:
o   It requires rate of return to calculate discounted payback period.
o   It also doesn’t consider the cash flows after the discounted payback period.

Example: In project A initial cost is Rs.20, 000 and future cash flow are as follows: Rs.5000, Rs.8000, Rs.2000, Rs.6000 and Rs.15000 Find out the discounted payback period assuming the cost of capital is 8%?

Year
Future Cash flows
R=8%
Discounted present Value
Cumulative Present Value (20,000)
1
5000
1.08
4629.62
(15,370.38)
2
8000
1.16
6896.55
(8,473.83)
3
2000
1.25
1600
(6,873.83)
4
6000
1.36
4411.76
(2,462.07)
5
15000
1.46
10273.97
7,811.9
Total
36000
27811.90

Discounted payback period = (A-1) + Cost of investment-Cumulative Cash Flows (A- 1)/Present Value of Cash Flows A

= (5-1) + 20, 000-17537.93/ 10273.97
= (4) +2462.07/ 10273.97
= 4+0.239
=4.24 or 4 year 87 days (0.24*365)
Or 
=4+2,462.07/10,273.97
= 4.24 years




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