Payback Period Method for Capital Budgeting Decisions:
Learning Objectives of the Article:
- Define and Explain payback period.
- Determine the payback period for an
investment project.
- What are the advantages and
disadvantages of Payback method?
Definition and Explanation:
The payback is another method to evaluate an investment project. The
payback method focuses on the payback period.
The payback period is the
length of time that it takes for a project to recoup its initial cost out of the
cash receipts that it generates. This period is some times referred to as" the
time that it takes for an investment to pay for itself." The basic premise of
the payback method is that the more quickly the cost of an investment can be
recovered, the more desirable is the investment. The payback period is expressed
in years. When the net annual cash inflow is the same every year, the following
formula can be used to calculate the payback period.
Formula / Equation:
The formula or equation for the calculation of
payback period is as follows:
Payback period = Investment required / Net annual cash
inflow*
*If new equipment is replacing old
equipment, this becomes incremental net annual cash inflow.
To illustrate the payback method, consider the
following example:
Example:
York company needs a new milling machine. The company is considering two
machines. Machine A and machine B. Machine A costs $15,000 and will reduce
operating cost by $5,000 per year. Machine B costs only $12,000 but will also
reduce operating costs by $5,000 per year.
Required:
- Calculate payback period.
- Which machine should be purchased according to payback method?
Calculation:
Machine A payback period = $15,000 / $5,000 = 3.0 years
Machine B payback period = $12,000 / $5,000 = 2.4 years
According to payback
calculations, York company should purchase machine B, since it has a shorter
payback period than machine A.
Evaluation of the Payback Period Method:
The payback method is not a true measure of the profitability of an
investment. Rather, it simply tells the manager how many years will be required
to recover the original investment. Unfortunately, a shorter payback period does
not always mean that one investment is more desirable than another.
To illustrate, consider again the two machines used in the example above.
since machine B has a shorter payback period than machine A, it appears that
machine B is more desirable than machine A. But if we add one more piece of
information, this illusion quickly disappears. Machine A has a project 10-years
life, and machine B has a projected 5 years life. It would take two purchases of
machine B to provide the same length of service as would be provided by a single
purchase of machine A. Under these circumstances, machine A would be a much
better investment than machine B, even though machine B has a shorter payback
period. Unfortunately, the payback method has no inherent mechanism for
highlighting differences in useful life between investments. Such differences
can be very important, and relying on payback alone may result in incorrect
decisions.
Another criticism of payback method is that it does not consider the time
value of money. A cash inflow to be received several years in the future is
weighed equally with a cash inflow to be received right now. To illustrate,
assume that for an investment of $8,000 you can purchase either of the two
following streams of cash inflows:
|
Years |
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
|
Stream 1 |
|
|
|
|
$8,000 |
$2,000 |
$2,000 |
$2,000 |
$2,000 |
|
Stream 2 |
|
$2,000 |
$2,000 |
$2,000 |
$2,000 |
$8,000 |
|
|
|
Which stream of cash inflows would you prefer
to receive to receive in return for your $8,000 investment? Each stream has
a payback period of four years. Therefore, if payback method alone were
relied on in making the decision, you would be forced to say that the
streams are equally desirable. However from the point of view of the time
value of money, stream 2 is much more desirable than stream 1.
On the other hand, under certain conditions
the payback method can be very useful. For one thing, it can help identify
which investment proposals are in the "ballpark." That is, it can be used as
a screening tool to help answer the question, "Should I consider this
proposal further?" If a proposal does not provide a payback within some
specified period, then there may be no need to consider it further. In
addition, the payback period is often of great importance to new firms that
are "cash poor." When a firm is cash poor, a project with a short payback
period but a low rate of return might be preferred over another project with
a high rate of return but a long payback period. The reason is that the
company may simply need a faster return of its cash investment. And finally,
the payback method is sometimes used in industries where products become
obsolete very rapidly - such as consumer electronics. Since products may
last only a year or two, the payback period on investments must be very
short.
|
In
Business | Capital Budgeting in Academia
Capital budgeting techniques are
widely used in large nonprofit organizations. A survey of universities
in the United Kingdom (UK) revealed that 41% use the net present value
method, 23% use the internal rate of return method, 29% use the payback
method, and 11% use the accounting rate of return method. (Some
universities use more than one method.) The central
Funding Council of the United Kingdom
requires that the net present value method be used for projects whose
lifespan exceed 20 years.
Source: Paul
Cooper, "Management Accounting Practices in Universities," Management
Accounting (U.K.), February 1996, pp. 28 - 30. |
Extension of Payback Method:
The payback period is calculated by dividing
the investment in a project by the net annual cash inflows that the project
will generate. If equipment is replacing old equipment then any salvage to
be received on disposal of the old equipment should be deducted from the
cost of the new equipment, and only the incremental investment should be
used in payback computation. In addition, any depreciation deducted in
arriving at the project's net operating income must be added back to obtain
the project's expected net annual cash inflow. To illustrate consider the
following data:
Example 2:
Goodtime Fun Centers, Inc., operates many
outlets in the eastern states. Some of the vending machines in one of its
outlets provide very little revenue, so the company is considering removing
the machines and installing equipment to dispense soft ice cream. The
equipment would cost $80,000 and have an eight-year useful life. Incremental
annual revenues and costs associated with the sale of ice cream would be as
follows:
| Sales |
$150,000 |
| Less cost of ingredients |
90,000 |
| |
|
| Contribution margin |
60,000 |
| |
|
| Less fixed expenses: |
|
|
Salaries |
27,000 |
|
Maintenance |
3,000 |
|
Depreciation |
10,000 |
| |
|
| Total fixed expenses |
40,000 |
| |
|
| Net operating income |
$20,000 |
| |
=========== |
The vending machines can be sold for a $5,000
scrap value. The company will not purchase equipment unless it has a payback
of three years or less. Should the equipment be purchased? An analysis of
the payback period for the proposed equipment is given below:
|
Step 1: Compute the
net annual cash inflow
Since the net annual cash inflow is not
given, it must be computed before the payback period can be determined: |
| |
|
| Net operating income
(given above) |
$20,000 |
| Add: Noncash deduction for
depreciation |
10,000 |
| |
|
| Net annual cash inflow |
$30,000 |
| |
========= |
| |
|
|
Step 2: Compute the
payback period Using
the net annual cash inflow figure from above, the payback period can be
determined as follows: |
| |
|
| Cost of the new equipment |
$80,000 |
| Less salvage value of old
equipment |
5,000 |
| |
|
| Investment required |
$75,000 |
| |
========= |
| |
|
|
Payback period =
Investment required / Net annual cash inflow
= $75,000 / $30,000
= 2.5 years |
Several things should be noted from the above
solution. First, notice that depreciation is added back to net operating
income to obtain the net annual cash inflow from the new equipment.
Depreciation is not a cash outlay; thus, it must be added back to net
operating income to adjust it to a cash basis. Second, notice in the payback
computation that the salvage value from the old machines has been deducted
from the cost of the new equipment, and that only the incremental investment
has been used in computing the payback period.
Since the proposed equipment has a payback
period of less than three years, the company's payback requirement has been
met.
Payback and Uneven Cash Flows:
When the cash flows associated with an
investment project changes from year to year, the simple payback formula
that we outlined earlier cannot be used. To understand this point consider
the following data:
Example:
|
Year |
Investment |
Cash Inflow |
| 1 |
$4,000 |
$1,000 |
| 2 |
|
0 |
| 3 |
|
2,000 |
| 4 |
2,000 |
1,000 |
| 5 |
|
500 |
| 6 |
|
3,000 |
| 7 |
|
2,000 |
| 8 |
|
2,000 |
What is the payback period on this investment?
The answer is 5.5 years, but to obtain this figure it is necessary to track
the unrecovered investment year by year. The steps involved in this process
are shown below:
|
Year |
Beginning Unrecovered Investment |
Investment |
Cash Inflow |
Ending Unrecovered Investment
(1) + (2) - (3) |
|
1 |
$ 0 |
$4,000 |
$1,000 |
$3,000 |
|
2 |
3,000 |
|
0 |
3,000 |
|
3 |
3,000 |
|
2,000 |
1,000 |
|
4 |
1,000 |
2,000 |
1,000 |
2,000 |
|
5 |
2,000 |
|
500 |
1,500 |
|
6 |
1,500 |
|
3,000 |
0 |
|
7 |
0 |
|
2,000 |
0 |
|
8 |
0 |
|
2,000 |
0 |
| |
|
|
|
|
| |
|
|
|
|
By the middle of the sixth year, sufficient
cash inflows will have been realized to recover the entire investment of
$6,000 ($4,000 + $2,000)
|
In Business |
Rapid Obsolescence
Intel Corporation invests a billion to a
billion and half dollars to fabricate computer processor chips such as
the Pentium IV. But the fab plants can only be used to make
state-of-the-art chips for about two years. By the end of that time, the
equipment is obsolete and the plant must be converted to making less
complicated chips. Under such conditions of rapid obsolescence, the
payback method may be the most appropriate way to evaluate investments.
If the project does not pay back within a few years, it may never pay
back its initial investment.
Source: "Pentium at a
Glance," Forbes ASAP, February 26, 1996, p.66. |
|
