Financial methods in environmental decisions
Financial methods in environmental decisions

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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

20 000 divided by 5000 equals four years

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

prefix pound of 45 000 plus prefix pound of 35 000 plus prefix pound of 20 000 equals prefix pound of 10 times zero 000

Activity 3 Payback period

Timing: 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

Timing: 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
01234567
1Capital cash inflows
Profits on lorry trade-in values5
Modernisation grant50
2Revenue cash inflows
Profits from increased sales45556575858585
Reduction of insurance premiums5555555
Saving of outside repair and maintenance costs607386100113113113
3Total cash inflowTotal 55Total 110Total 133Total 156Total 180Total 203Total 203Total 203
4Capital cash outflows
Site clearance and preparation20
New buildings150
Fixtures, fittings, etc.50
New lorries170
Garage machinery and new mechanical handling equipment20
Installation15
5Revenue cash outflows
Increase in business rates3333333
Increase in water rates15161717181920
Payroll791012131313
Material costs
Garage power costs
6Total cash outflowTotal 425Total 25Total 28Total 30Total 32Total 34Total 35Total 36
7Net cash flowTotal (370)Total 85Total 105Total 126Total 148Total 169Total 168Total 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.

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