Corporate Finance - Payback Period

Payback Period
Payback period (PP) is the number of years it takes for a company to recover its original investment in a project, when net cash flow equals zero. In the calculation of the payback period, the cash flows of the project must first be estimated. The payback period is then a simple calculation.

Formula 11.10

PP = years full recovery + unrecovered cost at beginning of last year
                                                cash flow in last year
The shorter the payback period of a project, the more attractive the project will be to management. In addition, management typically establishes a maximum payback period that a potential project must meet. When two projects are compared, the project that meets the maximum payback period and has the shortest payback period is the project to be accepted. It is a simplistic measure, not taking into account the time value of money, but it is a good measure of a project's riskiness.
Look Out!
For payback periods, the decision rules are as follows:
If payback period < the minimum payback, accept the project
If payback period > the minimum payback, reject the project

Example: Payback Period
Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity to its existing plant. The company estimates the cash flows for each machine to be as follows:

Figure 11.2: Expected after-tax cash flows for the new machines

Calculate the payback period of the two machines using the above cash flows and decide which new machine Newco should accept. Assume the maximum payback period the company establishes is five years.

First it would be helpful to determine cumulative cash flow for the machine project. This is done in the following table:

Figure 11.3: Cumulative cash flows for Machine A and Machine B

Payback period for Machine A = 4 + 1,000 = 4.67

Payback period for Machine B = 2 + 0 = 2.00
Both machines meet the company's maximum payback period. Machine B, however, has the shortest payback period and is the project Newco should accept.

2. Discounted Payback Period
The one issue we mentioned with the payback period is that it does not take into account the time value of money, but the discounted payback period does.The discounted payback period discounts each of the estimated cash flows and then determines the payback period from those discounted flows.

Example: discounted payback period
Using our last example above, determine the discounted payback period for Machine A and Machine B, and determine which project Newco should accept. As calculated previously, Newco's cost of capital is 8.4%.

Figure 11.4: Discounted cash flows for Machine A and Machine B

Payback period for Machine A = 5 + 147 = 5.24

Payback period for Machine B = 2 + 262 = 2.22

Machine A now violates management's maximum payback period of five years and should thus be rejected. Machine B meets management's maximum payback period of five years and has the shortest payback period.
Net Present Value (NPV) and the Internal Rate of Return (IRR)
Related Articles
  1. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  2. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  3. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  4. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  5. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  6. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  7. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  8. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  9. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  10. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!