Payback Period Method for Capital Budgeting Decisions


Payback Period Method for Capital Budgeting Decisions:

Learning Objectives of the Article:

  1. Define and Explain payback period.
  2. Determine the payback period for an investment project.
  3. 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 AcademiaCapital 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 inflowSince 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 periodUsing 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 ObsolescenceIntel 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.

You may also be interested in other articles from “capital budgeting decisions” chapter:

  1. Capital Budgeting – Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value – Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method – Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method – Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables

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