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 following 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 = 4.4

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. Investing

    Payback Period

    Payback 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 ...
  2. Small Business

    An Introduction to Capital Budgeting

    Firms use capital budgeting to determine if a project, like building a new plant or developing a new product, is worth pursuing.
  3. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  4. Investing

    Will Your Home Remodel Pay Off?

    Some renovations will mean a bigger sale price on your home, while others will just cost you.
  5. Taxes

    How Long Until Your Hybrid Pays Off?

    Buying a hybrid vehicle to save money on fuel costs is an appealing idea, but how long will you have to drive that fuel-sipper to break even on the high price tag?
  6. Insights

    Coming Soon: A Vending Machine For Pot

    High-tech biometric scanning machine could spit out age-controlled substances for customers
  7. Investing

    States That Spend The Most On Lottery Tickets

    Here are the areas in the U.S. that spend plenty of money on lottery tickets.
  8. Investing

    Boston Invaded by Automated Burger Machine

    With U.S. comps sales sagging again, McDonald's is pushing its new Big Macs with a free burger ATM.
Frequently Asked Questions
  1. Can I fund a Traditional IRA, a 403(b) or a Roth IRA using pension money?

    Can pension money be used to fund other retirement accounts?
  2. What are unregistered securities or stocks?

    Before securities, like stocks, bonds and notes, can be offered for sale to the public, they first must be registered with ...
  3. How does a company move from an OTC market to a major exchange?

    The over-the-counter market is not an actual exchange like the NYSE or Nasdaq. Instead, it is a network of companies that ...
  4. Can I roll a traditional IRA into a 529 college account for my grandchild?

    The short answer: Not without paying taxes. But as with much of the tax code, there are various nuisances and exemptions ...
Trading Center