Payback period is the time duration required to recoup the investment committed to

a project. Business enterprises following payback period use "stipulated payback

period", which acts as a standard for screening the project.
Payback period is the time in which the initial cash outflow of an investment is expected to
be recovered from the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.

Formula
Computation Of Payback Period
When the cash inflows are uniform the formula for payback period is cash outflow
divided by annual cash inflow
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate
payback period is:

Payback Period =

Initial Investment
Annual Cash Inflow

Computation Of Payback Period

When the cash inflows are uneven, the cumulative cash inflows are to be arrived at
and then the payback period has to be calculated through interpolation
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each
period and then use the following formula for payback period:

Payback Period = A +

B
C

In the above formula,

A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A

Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million.
The project is expected to generate $25 million per year for 7 years. Calculate the payback
period of the project.

Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
Example 2: Even Cash Flows
A project costs Rs 2,00,000 and yields an annual cash inflow of Rs 40,000 for 8 years
Calculate Payback period

Initial Investment
Annual Cash Inflow

Payback Period =
=2,000,0000/40,000=5 years
Example 1: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50

million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million
in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the
project.
Solution

(cash flows in millions) Cumulative

Year
Cash Flow Cash Flow
0
(50)
(50)
1
10
10
2
13
23
3
16
39
4
19
58
5
22
60
Payback Period
=3+ ([39-50]/19)
= 3 + (|$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years
Example 2: Uneven Cash Flows
The cost of machine purchased at 50,000 and is expected to yield cash inflows after tax Rs
5,000, Rs 10,000, Rs 15,000, Rs 20,000, Rs 25,000 and Rs 30,000 during period of six
years of life. Compute payback period
Year

Annual cash inflow

Cumulative cash inflow

5,000

5,000

10,000

15,000

15,000

30,000

20,000

50,000

25,000

75,000

30,000

1,05,000

Payback period 4 years Return of investment of 50,000 Rs

Advantages and Disadvantages

Advantages of payback period are:
1.

Payback period is very simple to calculate.

2.

It can be a measure of risk inherent in a project. Since cash flows that occur later in
a project's life are considered more uncertain, payback period provides an indication of
how certain the project cash inflows are.

3.

For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.

Disadvantages of payback period are:

1.

Payback period does not take into account the time value of money which is a
serious drawback since it can lead to wrong decisions. A variation of payback method
that attempts to remove this drawback is calleddiscounted payback period method.

2.

It does not take into account, the cash flows that occur after the payback period.
Year
0

Project A
(Rs.3,000)

B
(Rs.3,000)

C
(Rs.3,000)

D
(Rs.3,000)

300

300

600

2,700

600

900

300

900

900

1,500

-300

2,100

1,200

1,500

-1,200

3,900

3,750

1,800

Payback 2 yrs.

4 yrs.

4 yrs.

3 yrs.

PRESENT VALUE (PV) FACTOR

The present value (PV) factor is used to derive the present value of a receipt of cash on a
future date. The concept of the present value factor is based on the time value of money that is, money received now is worth more than money received in the future, since money
received now can be reinvested in an alternative investment to earn additional cash.

The PV factor is greater for cash receipts scheduled for the near future, and smaller
for receipts that are not expected until a later date. The factor is always a number
less than one.
The formula for calculating the present value factor is:
P = (1 / (1 + r)n)

Where:

P = The present value factor

r = The interest rate
n = The number of periods over which payments are made
Discounted pay-back period
Problem
The company is considering investment of Rs. 1,00,000 in a project. The
following are the income forecasts, after depreciation and tax, 1st year Rs.
10,000, 2nd year Rs. 40,000, 3rd year Rs. 60,000, 4th year Rs. 20,000 and 5th
year Rs. Nil. From the above information you are required to calculate: (1) Payback Period (2) Discounted Pay-back Period at 10% interest factor.
Solution:
P = (1 / (1 + r)n)

Present value factor for period 1=1/(1+10/100)1

=1/(1.1)
=.9091
Present value factor for period 1=1/(1+10/100)2
=.8265

Average Rate of Return Method (ARR)

Average Rate of Return Method (ARR) or Accounting Rate of Return Method: Average
Rate of Return Method is also termed as Accounting Rate of Return Method. This
method focuses on the average net income generated in a project in relation to the
project's average investment outlay. This method involves accounting profits not
cash flows and is similar to the pelformance measure of return on capital employed.
The average rate of returr. can be determined by the following equation:
Average Rate of Return Method= Average Income/ Average Investments*100
or
= Cash Flow - (After Depreciation and Tax)/ Original
Investments
= No. of Projects/ No. of Years*100

Average Investment = Original Investment/2

or
=Original Investment - Scrap Value of the Project / 2
Advantages
(1) It considers all the years involved in the life of a project rather than only payback years.
(2) It applies accounting profit as a criterion of measurement and not cash flow.
Disadvantages
(1) It applies profit as a measure of yardstick not cash flow.
(2) The time value of money is ignored in this method.
(3) Yearly profit determination may be a difficult task.
Illustration: 6 From the following information you are required to find out Average
Rate of Return : An investment with expenditure of Rs.l0,OO,OOO is expected to
produce the following profits (after deducting depreciation)
1st Year Rs. 80,000
2nd Year Rs. 1,60,000
3rd Year Rs. 1,80,000
4th Year Rs. 60,000
Solution:
Calculation of Accounting Rate of Return
Average Rate of Return= Average Annual Profits - Depreciation and Taxes = x 100
---------------------------------------- Average Investments 80,000 + 1,60,000 + 1,80,000 +
60,000 Average Annual Profits = ------------------------------ 4 = 4,80,000 4 = Rs.
1,20,000 Average Investments (Assuming Nil Scrap Value) = = Average Rate of
Return = Investment at beginning + 2 10,00,000 + 0 2 1,20,000 + 0 5,00,000
Investment at the end = Rs. 5,00,000 x 100 = 24% 65/ The percentage is compared
with those of other projects in order that the investment yielding the highest rate of
return can be selected.
Net present value method (also known as discounted cash flow method) is a popular capital
budgeting technique that takes into account the time value of money. It uses net present value
of the investment project as the base to accept or reject a proposed investment in projects like

purchase of new equipment, purchase of inventory, expansion or addition of existing plant

assets and the installation of new plants etc.
First, I would explain what is net present value and then how it is used to analyze investment
projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the present
value of cash outflows that occur as a result of undertaking an investment project. It may be
positive, zero or negative. These three possibilities of net present value are briefly explained
below:
Positive NPV:
If present value of cash inflows is greater than the present value of the cash outflows, the net
present value is said to be positive and the investment proposal is considered to be acceptable.
Zero NPV:
If present value of cash inflow is equal to present value of cash outflow, the net present value is
said to be zero and the investment proposal is considered to be acceptable.
Negative NPV:
If present value of cash inflow is less than present value of cash outflow, the net present value is
said to be negative and the investment proposal is rejected.
The summary of the concept explained so far is given below: