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Module 2: Payback Period

Payback Period
A Capital - budgeting criterion defined as the number of years required to recover the initial cash investment.

Discounted payback period
A variation of the payback period decision criterion defined as the number of years required to recover the initial cash outlay from the discounted net cash flows.


Payback Period Example

Project
A
Qumulative cashflow: Project A
B
Qumulative cashflow: Project B
Initial cash outlay
-$10,000
-$10,000
-
Annual free cash flow:
Year 1
$6,000
6,000
$5,000
$5,000
Year 2
4,000
10,000
5,000
10,000
Year 3
3,000
0
Year 4
2,000
0
Year 5
1,000
0

PAYBACK PERIOD A = 2 YEAR

PAYBACK PERIOD B = 2 YEAR

PAYBACK PERIOD A= 2 YEAR = PAYBACK PERIOD B = 2 YEAR

* Problems -a's cashflow come faster (year one: A=6,000, B= 5,000)

- Time value of money

- They can generate more cashflows after payback

discounted payback = 3.0 +$74/$1,068=3.07 years

Discounted Payback Period Example Using a 17 Percent Required Rate of Return

Project A

Year
Undercounted
Free Cash Flows


Discounted
Free Cash Flows
Cumulative
Discounted
Free Cash Flows
0
      $10,000
   1.0
      $10,000
-$10,000
1
6,000
.855
5,130
-    4,870
2
4,000
.731
2,924
-    1,946
3
3,000
.624
1,872
         -74
4
2,000
.534
1,068
        994
5
1,000
.456
              456
    1,450

Project B

Year
Undercounted
Free Cash Flows


Discounted
Free Cash Flows
Cumulative
Discounted
Free Cash Flows
0
-$10,000
 1.0
-$10,000
-$10,000
1
     5,000
.855
       4,275
-    5,725
2
     5,000
.731
        3,655
-    2,070
3
            0
.624
               0
-    2,070
4
            0
.534
               0
  -     2,070 
5
            0
.456
               0
-    2,070



Weak Points of Payback Period Technique

1. It ignores cash flow after payback period
2. It ignores time value of money.

Good Points of Payback Period

1. they deal with cash flows, not accounting profits
2. they are easy to visualize, quickly understood, and easy to calculate
3. they are often used as a rough screening devices to eliminate projects whose returns do not materialize until later years.