| Table 3.1: Payback Period for Project A ($) | ||
| Year | Payback | Net Cash Flow |
| 0 | (1 000 000) | (1 000 000) |
| 1 | (900 000) | 100 000 |
| 2 | (750 000) | 150 000 |
| 3 | (500 000) | 250 000 |
| 4 | (200 000) | 300 000 |
| 5 | 50 000 | 250 000 |
| 6 | 250 000 | 200 000 |
| 7 | 450 000 | 200 000 |
Thus, Payback in exactly 4 years and 9.6 months.
This is the official layout the IB wants you to follow. So, whenever you have to present payback period, present it like this!
What do all these numbers mean?
Net cash flow column will be given to you in the case study. It is the cash flow the business over the years. Payback column is what you use to calculate in what time the project will be repaid. You start with 0 (year in which business purchased project A) and the number is negative as that represents expenditure. In this case, it cost $500.000. We use brackets to indicate that it is a negative number. In year 1, it is expected that the business will have a cash influx of $100.000 – so, what we do is simply add that to the initial expenditure. We repeat this over and over again until we reach a year under the ‘payback’ column that’s positive or zero. This means that in that year, with the expected cash influx given, we have repaid investment in full (in our example, that is year 4). Now we know that we expect to repay project A in year 4, but we do not know in exactly how many months. So, we divide the ‘payback’ amount for that year by the expected cash flow for that year (in this case these are numbers 0 and 150). We then multiply all this by 12. In our case, the payback period is exactly 4 years and 9.6 months.
If we used this method to appraise different investment projects, we would choose the investment that pays back the fastest.
Frequently Asked Questions about Payback Period
What is the Payback Period?
How do you calculate the Payback Period? What is the formula?
For Even Cash Flows (Same amount each period):
Payback Period = Initial Investment / Annual Cash Inflow
For Uneven Cash Flows:
You calculate the cumulative cash flow for each period. The payback period is the last period with a negative cumulative cash flow plus the fraction needed to cover the remaining investment:
Payback Period = Year before full recovery + (Unrecovered amount at start of year / Cash flow during the year)
For example, if $100 is unrecovered at the start of Year 3, and Year 3's cash flow is $400, the fraction is $100/$400 = 0.25 years. If Year 2 was the last year with negative cumulative cash flow, the payback period would be 2 + 0.25 = 2.25 years.What does the Payback Period tell you?
- A **shorter** payback period generally indicates a more liquid investment, as the initial capital is recovered sooner.
- It's often used as a rough measure of **risk**, as projects that recover costs faster are perceived as less risky (less time for things to go wrong).
What are the limitations of the Payback Period method?
- Ignores Time Value of Money: The basic payback period does not account for the fact that money received in the future is worth less than money received today.
- Ignores Cash Flows After Payback: It completely disregards any cash flows that occur after the payback period is reached, potentially leading to the rejection of highly profitable long-term projects.
- Arbitrary Cutoff: The decision rule (setting a maximum acceptable payback period) is often subjective.
- Doesn't Measure Total Profitability: It only focuses on cost recovery time, not the overall profitability or value generated by the project.
Does Depreciation Expense affect the Payback Period?
However, depreciation *does* affect cash flow indirectly through its impact on taxes. Depreciation is tax-deductible, creating a "tax shield" that reduces the amount of cash paid for taxes. If tax effects are considered, depreciation's impact on cash flow *through taxes* will affect the payback period. Most basic payback calculations simplify this and use pre-tax cash flows.