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.

Answer:
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
                                                          1,500

Payback period for Machine B = 2 + 0 = 2.00
                                                          0
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

Answer:
Payback period for Machine A = 5 + 147 = 5.24
                                                           616

Payback period for Machine B = 2 + 262 = 2.22
                                                         1178

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. 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?
  2. 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.
  3. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  4. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  5. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  6. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  7. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  8. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  9. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
  10. Professionals

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
RELATED TERMS
  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, ...
RELATED FAQS
  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 >>
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!