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. Investing

    Understanding The Discounted Payback Period

    It’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.
  3. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  4. 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?
  5. Managing Wealth

    What's a Hurdle Rate?

    Hurdle 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 ...
  6. 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.
  7. Tech

    Cloud Battle Gets More Intelligent (MSFT, AMZN)

    It seems that machine learning technology is going to be the next battleground for market share within the cloud.
  8. Investing

    The Wonders Of Convertible Bonds

    Ever wondered what exactly a convertible bond does? Read the features of a convertible bond and learn how important the conversion factor is to you as an investor.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center