Lecture 3 – Payback Period

Project Cost & Finance (PCFM)

MSPM

Ms. Maria Iqbal

 Scheme
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 Payback Period

 Introduction

 Calculation of Payback Period

◼ With equal Cash Inflows (Annuity)

◼ With Unequal Cash Inflows

 Strengths and Weaknesses

 Practice Questions
 Payback Period
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❑ Payback Period is the number of years it takes to recover the initial investment.

❑ It is the easiest investment evaluation method to perform, but the theoretically

worst method available as the timing and riskiness of the cash flows are ignored.

❑ The reason it continues to be used is that it is easy to understand and explain.

❑ Small business are especially likely to use the payback method if the owners or
managers are not well versed in financial principles.

❑ Shorter (smaller) Payback Period is preferred.

 Cash Inflows & Cash Outflows
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❑ Investment is also known as Initial Cash Outflow (ICOF)

❑ Investments, cash outflows, payments, expenses, disbursements are represented

with a –ve sign or ( ).

❑ Cash inflows, revenues, incomes, receipts have a +ve or no sign.

 Calculating Payback Period
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❑ Payback period can be calculated using following formula when:

❑ We have an initial investment and constant/fixed amount of income

(annuity) without any further investment/expenses/cash outflows.

❑ We have an initial investment and a constant/fixed amount of savings

(whereas, Savings = Income – Expenses).
 Calculating Payback Period
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 Calculating Payback Period
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❑ Payback period can be calculated using following formula when:

❑ We have an initial investment and constant/fixed amount of income

(annuity) without any further investment/expenses/cash outflows.

❑ We have an initial investment and a constant/fixed amount of savings

(whereas, Savings = Income – Expenses).
 Payback Period
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Time Period Investment Income or Savings Remaining

(Years) or Expense Revenue (Income – Expense) Investment
0 (50M) - (50M) (50M)
1 (80M) 100M 20M 20M – 50M = (30M)
2 (110M) 130M 20M 20M – 30M = (10M)

3 (120M) 140M 20M 20M – 10M = 10M

4 (100M) 120M 20M

 Payback Period
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Time Period Investment Income or Savings Remaining

(Years) or Expense Revenue (Income – Expense) Investment
0 (50M) - (50M) (50M)
1 (80M) 100M 20M 20M – 50M = (30M)
2 (110M) 130M 20M 20M – 30M = (10M)

3 (120M) 140M 20M 20M – 10M = 10M

4 (100M) 120M 20M

 Calculating Payback Period Using Formula
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18-04-2020 18-04-2021 18-04-2022 18-04-2023 18-04-2024

0 1 2 3 4

Expenses (50M) (80M) (110M) (120M) (100M)

Revenue 100M 130M 140M 120M

Cost Savings 20M 20M 20M 20M

Payback Period (Pb) = Investment = 50M = 2.5 years (2 years & 6 months)
Annual Cash Saving 20M
 Calculating Payback Period
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 Calculating Payback Period
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Time Period Investment or Income or Savings Remaining

(Years) Expense Revenue (Income – Expense) Investment
0 (700,000) - (700,000) (700,000)
1 - 200,000 200,000 (500,000)
2 - 300,000 300,000 (200,000)

3 - 400,000 400,000 200,000

4
5
 Calculating Payback Period
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Time Period Investment or Income or Savings Remaining

(Years) Expense Revenue (Income – Expense) Investment
0 (700,000) - (700,000) (700,000)
1 - 200,000 200,000 (500,000)
2 - 300,000 300,000 (200,000)

3 - 400,000 400,000 200,000

4
5
 Payback Period
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Time Period Investment Income or Savings Remaining

(Years) or Expense Revenue (Income – Expense) Investment
0 (50M) - (50M) (50M)
1 (80M) 90M 10M 10M – 50M = (40M)
2 (100M) 110M 10M 10M – 40M = (30M)
3 (120M) 150M 30M 30M – 30M = 0
4 (100M) 150M 50M 50M – 0M = 50M
 Payback Period
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Time Period Investment Income or Savings Remaining

(Years) or Expense Revenue (Income – Expense) Investment
0 (50M) - (50M) (50M)
1 (80M) 90M 10M 10M – 50M = (40M)
2 (100M) 110M 10M 10M – 40M = (30M)
3 (120M) 150M 30M 30M – 30M = 0
4 (100M) 150M 50M 50M – 0M = 50M
 Strengths & Weaknesses
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Strengths Weaknesses

Easy to use & understand Does not account for TVM

Can be used as a measure of liquidity Does not consider cash flows beyond PbP

Easier to forecast short-term than long- Cutoff period (what value of Payback
term cash flows Period is acceptable) is subjective
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 Practice Questions
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Time Period
Cash Flows Cumulative
(Years)
0 (1,000,000) (1,000,000)
1 100,000 (900,000)
2 300,000 (600,000)

3 700,000 100,000

4 700,000 800,000
 Practice Questions
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Time Period
Cash Flows Cumulative
(Years)
0 (1,000,000) (1,000,000)
1 100,000 (900,000)
2 300,000 (600,000)

3 700,000 100,000

4 700,000 800,000
 Practice Questions
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Annual Cash Flows Recoveries by Year:

Year 1 $15,000 Amount to be recovered $(60,000)
Year 2 $16,500 15,000
Recovered in Year 1
Year 3 $18,150 (45,000)
Year 4 $19,965 16,500
Recovered in Year 2
(28,500)
Interpretation: You expect to
18,150
recover your cash investment in Recovered in Year 3
$(10,350)
3.52 years.
Recovered in Year 4 19,965
Evaluation: Because the cash is Balance at end of Year 4 $9,615
expected to be recovered in less
than 4 years, the investment Fraction of Year 4:
might be acceptable (if balance at $10,350/S19,965 = 0.5184
the end of year 4 is reasonable). Payback period = 3.52 years
 Practice Questions
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You have two investment proposals involving same ICOF of US$210,000 in each
case (as on 01-01-2021). The end of year Cash Inflows after Tax (CIFAT) in USD
is given below:

2021 2022 2023 2024 2025 2026

Choice A $50,000 $40,000 $40,000 $50,000 $30,000 $35,000

Choice B US$ 65,000 each year for next 5 years

Required:
a. Find Pay Back Period for both choices.
b. Which choice is better?
 Practice Questions
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A project manager is evaluating two mutually exclusive project proposals (X & Y)

with the following End of Year Annual Cash Flows:

Year Net CFs Project X Net CFs Project Y

2020 -$100,000 -$150,000
2021 $40,300 $75,200
2022 $50,400 $59,300
2023 $35,500 $65,400

Required: Indicate which project is acceptable based on Payback period of projects.

 Practice Questions
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Q.

Initial Investment = Rs 40M

Annual Cash Saving for next 8 years= Rs 7.0M Per year
Pb = ?

Q.

Initial Investment = US$ 17M

Duration of Project = 07 Years
Average Annual Cash Saving = US$ 15M
Pb = ?
 Payback Period
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Time Period Investment Income or Savings Remaining

(Years) or Expense Revenue (Income – Expense) Investment
0 (50M) - (50M) (50M)
1 (80M) 90M 10M 10M – 50M = (40M)
2 (110M) 100M (10M) - 10M – 40M = (50M)
3 (120M) 150M 30M 30M – 50M = (20M)
4 (100M) 150M 50M 50M – 20M = 30M