Financial methods in environmental decisions

Payback period

The payback period is the simplest of all financial appraisal methods. While the results can be very misleading, it is a commonly used technique and is a quick method of assessing whether a proposed project is worth further investigation. All that the payback period calculates is how long it will take to recover the initial project investment out of the subsequent net cash flows, that is, how long it will take for a project to recoup the initial capital outlay.

As a simple example, if you invest £20 000 in a project for which you estimate that the positive net cash flow each year – that is, the excess of cash inflows over cash outflows – will be £5000, you expect to recover your initial investment in

Even if the net cash flow varies year by year, it is just as simple to calculate the payback period. Consider a project A with an initial investment of £100 000 and an expected pattern of net cash flows (all positive) as follows:

  • year 1  £45 000
  • year 2  £35 000
  • year 3  £20 000
  • year 4  £20 000
  • year 5  £15 000

It is easy to see that it will take exactly three years to recover the initial investment because

Activity 3 Payback period

Allow 15 minutes to complete this activity

Now consider a project B in which the initial investment is also £100 000 but the subsequent pattern of net cash flows (all positive) is as follows:

  • year 1  £10 000
  • year 2  £20 000
  • year 3  £35 000
  • year 4  £45 000
  • year 5  £50 000

What is the payback period of this project?

Answer

Calculating the cumulative cash flow

  • year 1  £10 000
  • year 2  £30 000
  • year 3  £65 000
  • year 4  £110 000

So the payback period is somewhere between three and four years.

You can now see that, although the total net cash flows over the five-year project life are less in project A than in project B, the quite different pattern of cash flows would favour project A.

The chief advantage in using the payback period method is that it is easy to understand and to calculate. However it has the following serious limitations:

  • The method completely ignores positive net cash flows received after the payback point, whereas in project B it was these later cash flows that were the most significant.
  • The method looks entirely at cash flow and completely ignores how much has to be invested in comparison with the size of the profits.
  • The method assumes that all money is of equal value no matter when it is spent or received. Given the choice between receiving money now or in a year’s time, most people would opt for the cash in hand now – a lot can happen in a year.

Many organisations use the payback period method by itself and look for payback periods of two or at most three years. As a result, many worthwhile but longer-term projects, which would give a high rate of return on the investment, are never accepted. Therefore you should never use this method as the only assessment technique.

Activity 4 Fatcat Haulage

Allow 15 minutes to complete this activity

The cash flow statement for the Fatcat Haulage project shown in Table 2 has been revised from the statement shown in Table 1 to take into account variations in cash inflows and outflows.

Assume that the cash flow values are calculated as after tax and calculate the payback period for this project.

Table 2 Fatcat Haulage: revised cash flow statement (all money values in £000s)

Year
0 1 2 3 4 5 6 7
1 Capital cash inflows
Profits on lorry trade-in values 5
Modernisation grant 50
2 Revenue cash inflows
Profits from increased sales 45 55 65 75 85 85 85
Reduction of insurance premiums 5 5 5 5 5 5 5
Saving of outside repair and maintenance costs 60 73 86 100 113 113 113
3 Total cash inflow 55 110 133 156 180 203 203 203
4 Capital cash outflows
Site clearance and preparation 20
New buildings 150
Fixtures, fittings, etc. 50
New lorries 170
Garage machinery and new mechanical handling equipment 20
Installation 15
5 Revenue cash outflows
Increase in business rates 3 3 3 3 3 3 3
Increase in water rates 15 16 17 17 18 19 20
Payroll 7 9 10 12 13 13 13
Material costs
Garage power costs
6 Total cash outflow 425 25 28 30 32 34 35 36
7 Net cash flow (370) 85 105 126 148 169 168 167
Parentheses indicate a negative cash flow or a net cash outflow.

Answer

The payback period for the lorry modernisation project is about 3 years and 4 months. After the first three years, there is still £54 000 to be recovered from the year 4 net cash flow of £148 000.