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:
It is easy to see that it will take exactly three years to recover the initial investment because
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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:
What is the payback period of this project?
Calculating the cumulative cash flow
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:
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.
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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.
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 |
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.
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