Payback Period Method--Capital Budgeting Decisions:

1. Definition and Explanation
2. Formula of Payback Period
3. Example of Payback Method
4. Evaluation

Definition and Explanation:

The payback is another method to evaluate an investment project. The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is some times referred to as" the time that it takes for an investment to pay for itself." The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.

Formula:

The formula is as follows:

Payback period = Investment required / Net annual cash inflow*

*If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.

To illustrate the payback method, consider the following example:

Example:

York company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year.

Required:

• Calculate payback period.
• Which machine should be purchased according to payback method?

Calculation:

Machine A payback period = $15,000 / $5,000 = 3.0 years

Machine B payback period = $12,000 / $5,000 = 2.4 years

According to payback calculations, York company should purchase machine B, since it has a shorter payback period than machine A.

Evaluation of the Payback Period Method:

The payback method is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.

To illustrate, consider again the two machines used in the example above. since machine B has a shorter payback period than machine A, it appears that machine B is more desirable than machine A. But if we add one more piece of information, this illusion quickly disappears. Machine A has a project 10-years life, and machine B has a projected 5 years life. It would take two purchases of machine B to provide the same length of service as would be provided by a single purchase of machine A. Under these circumstances, machine A would be a much better investment than machine B, even though machine B has a shorter payback period. Unfortunately, the payback method has no inherent mechanism for highlighting differences in useful life between investments. Such differences can be very important, and relying on payback alone may result in incorrect decisions.

Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow to be received right now.

You may also be interested in other relevant articles:

• Capital Budgeting
• Net Present Present Value Method
• Internal Rate of Return Method
• Ranking Investment Projects
• Simple rate of Return Method
• Post Audit of Investment Projects

 

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