Project Selection: Payback Period

Payback Period – it is the time that takes for the cumulative sum of annual net cash inflows
from a project to equal the initial net cash today.
- An effective measure of investment risk.
- It answers the question: How long will it take the capital project to recover, or pay back,
the initial investment.
Formula for Payback Period
Payback Period = Initial Cash Outlay______
Annual net cost inflow (benefit)
Comparative Examples:
Comparative Example A:
Payback Period = Initial Cash Outlay______ PP = 120,000 Payback Period = 6.6 years
Annual net cost inflow (benefit) 18,200
Comparative Example B:
Payback Period = Initial Cash Outlay______ PP = 28,000 Payback Period = 10.8 years
Annual net cost inflow (benefit) 2,600

Need to consider before deciding on project selection using Payback Period

In using payback period analysis in order to evaluate investment proposals, management may
choose one of these rules to decide on project selection:
 Select the investments with the shortest payback periods.
 Select only those investments that have a payback period of less than a specified number
of years.
Limitations of using Payback Period
1. Payback period analysis ignores the time period beyond the payback period.
Example:
Assume, Allen Company is considering two alternative investments; each requires an initial
outlay of Php 30,000. Proposal Y returns Php 6,000 per year for five years, while proposal Z
returns Php 5,000 per year for eight years.
Y: 30,000/ 6,000 = 5 years Z: 30,000/ 5,000 = 8 years
But if the goal is to maximize income, proposal Z should be selected rather than proposal Y,
even though Z has longer payback period. This because:
Y total returns (P6,000 per year x 5 years) = Php 30,000
Z total returns (P5,000 per year x 8 years) = Php 40,000
2. Payback period analysis also ignores the time value of money.
Example:
Assume the following net cash flows are expected in the first three years from two capital
projects:
Net Cash Flows
Project Y Project Z
First Year P 15,000 P 9,000
Second Year 12,000 12,000
Third Year 9,000 15,000
P 36,000 P 36,000