Payback Period

Payback Period is the time required to recover the original cost of an investment from the net cash flows without considering the time value of money. In simple words, it is the time by which the project returns the original investment done.
Illustration 1: Ram gave Rs.1000 to John and John Returns the money back to Ram by giving Rs. 60 and Rs. 40 in two days. The payback period is 2 days as the original amount (Rs.100) was returned in that period.
  • In case of equal cash flows over the periods,


  • In the case of unequal cash flows over the periods,

Where,
  • X = Last period with a negative discounted cumulative cash flow
  • Y =Value of discounted cumulative cash flow at the end of the period X
  • Z = Discounted cash flow during the period after X.
An Investment with Shorter Payback Period is preferred over an investment with Longer Payback Period, this is due to two reasons:
  • As soon as the initial cost is recovered, the profit starts, hence the shorter payback period implies early profits.
  • Recovering the initial investment in a shorter time reduces the effect of Time Value of Money.
Illustration 2: Payback period focuses only on Return of Initial Investment and not on profitability, consider a case where the net cash flows cease immediately after the Payback Period.

Illustration 3: Calculation of Payback period is difficult in projects where the investment is spread over several periods through cash flows, consider a project wherein the investment of Rs. 10000 is required for 5 years.

Example 1: ABC Ltd. has invested Rs. 1000000.00 in a project that promises a net cash flow of Rs. 50000.00 every year, calculate the Payback Period for ABC ltd.
Solution:
Payback Period = Initial Investment / Cash Flow Per Period
                          = 1000000 / 50000 = 20
Hence, Payback Period = 20 years

Example 2: XYZ Ltd has invested Rs. 25000 in a project that promises net cash flows in the following order, calculate the Payback Period for ABC Ltd.
Year Year 1 Year 2 Year 3 Year 4 Year 5
Net Cash Flow 5000.00 8000.00 9000.00 8000.00 12000.00
Solution:
In such cases where the cash flow is uneven, the following steps are followed to calculate the Payback period
  • Step 1: Create a table of the net cash flow and the cumulative flow. Cumulative flow is the net cash balance after adjusting the net cash flow. The initial investment amount can be considered as a negative cash flow. The initial point i.e. year 0, will have a negative balance equal to the amount invested initially.
Year Net Cash Flow Cumulative Flow
0 -25000 -25000
1 5000 -20000
2 8000 -12000
3 9000 -3000
4 8000   5000
5 12000   17000
  • Step 2: Select the year which has the last negative cumulative flow. In above case it will be 3rd Year.
  • Step 3: Divide the Cumulative Flow of the year obtained in Step 2 by the net cash flow of the immediate next year. (Ignore the sign)
3000/8000 = 0.375 
  • Step 4: The answer is the sum of Step 2 and Step 3 i.e. 3.375 Years.
Hence, Payback Period of above cashflow is 3.375 years
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