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.
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.
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)
InvestingIt’s similar to a simple payback, but a discounted payback period accounts for money’s time value. It’s a more precise estimate of when investors will recover their total investment.
InvestingPayback period is the time it takes for an investment to generate an amount of income or cash equal to the cost of the investment. The shorter the payback period, the better the investment is ...
Small BusinessFirms use capital budgeting to determine if a project, like building a new plant or developing a new product, is worth pursuing.
InvestingWe look at three widely used valuation methods and figure out how companies justify spending.
Personal FinanceFind out how to determine whether refinancing will put you ahead or even more behind.
Small BusinessCalculating the net present value (NPV) of your investment projects using Excel.
InvestingSome renovations will mean a bigger sale price on your home, while others will just cost you.
Managing WealthHurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ...
Personal FinanceImproving cash flow in construction requires some sector-specific strategies.
Small BusinessUsing internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.