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
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?
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
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)
|1||Capital cash inflows|
|Profits on lorry trade-in values||5|
|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||Total 55||Total 110||Total 133||Total 156||Total 180||Total 203||Total 203||Total 203|
|4||Capital cash outflows|
|Site clearance and preparation||20|
|Fixtures, fittings, etc.||50|
|Garage machinery and new mechanical handling equipment||20|
|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|
|Garage power costs|
|6||Total cash outflow||Total 425||Total 25||Total 28||Total 30||Total 32||Total 34||Total 35||Total 36|
|7||Net cash flow||Total (370)||Total 85||Total 105||Total 126||Total 148||Total 169||Total 168||Total 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.