Payback PeriodPresented By: Hari Krishnan

Payback PeriodDefinition:

The Payback period is the amount of time that it take to recover your costs in a project.

FORMULA: Payback Period Even Or Uneven Even:

Payback Period = Initial Investment/ Annual Cash flows

Uneven:Paybeck Period=A+(B/C)

Where; A=The Last period with a negative cumulative cash flow

B=The absolute value of cumulative cash flow at the end of the period A;

C=The total cash flow during the period after A

ExampleEven Cash Flow:Company C is planning to

undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.

Cont..Payback Period = Initial Investment/ Annual Cash flows

=$105/$25 =4.2 year

Cont..Uneven Cash Flows.Company C is planning to undertake

another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.

Cont..

Payback Period= 3 + (|-$11M| ÷ $19M)= 3 + ($11M ÷ $19M)≈ 3 + 0.58≈ 3.58 years

(cash flows in millions) Year Cash Flow

CumulativeCash Flow

0 50 -50

1 10 -40

2 13 -27

3 16 -11

4 19 8

5 22 30

Payback Period RuleThe Decision Rule: the actual payback is

compared with a predetermined pay back, that is, the pay back set by the management in terms of the maximum period during which the investment must recovered. 

If the pay back period is less than the predetermined payback, then the project would be Accepted; if not, it would be rejected

Advantage of Payback Period It is very simple. It is easy to

understand and apply It is cost effectiveThe payback period measures the

direct relationship between annual cash inflows from Proposal and the net investment required

Disadvantage Of Payback Period

The pay back period entirely ignores the cash inflows that occur after the pay back period

The pay back period also ignores salvage value and total economic life of the project

It ignores the time value of money

Drawbacks of Payback PeriodDoes not consider all of the project’s case flows.

This project is clearly profitable, but we would accept it based on a 4 year payback criterion!

Thank You…!