PAY BACK PERIOD-Entrepreneurship Development CIA

The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred to as" the time that it takes for an investment to pay for itself." The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.

Formula / Equation: The formula or equation for the calculation of payback period is as follows: Payback period = Investment required / Net annual cash inflow

Example: York company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year. Required: Calculate payback period. Which machine should be purchased according to payback method? Calculation:

Machine A payback period = $15,000 / $5,000 = 3.0 years

Machine B payback period = $12,000 / $5,000 = 2.4 years

According to payback calculations, York Company should purchase machine B, since it has a shorter payback period than machine A.

ANALYSIS OF PAYBACK PERIOD The payback method is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another. To illustrate, consider again the two machines used in the example above. since machine B has a shorter payback period than machine A, it appears that machine B is more desirable than machine A. But if we add one more piece of information, this illusion quickly disappears. Machine A has a project 10-years life, and machine B has a projected 5 years life. It would take two purchases of machine B to provide the same length of service as would be provided by a single purchase of machine A. Under these circumstances, machine A would be a much better investment than machine B, even though machine B has a shorter payback period. Unfortunately, the payback method has no inherent mechanism for highlighting differences in useful life between

investments. Such differences can be very important, and relying on payback alone may result in incorrect decisions. Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow to be received right now. To illustrate, assume that for an investment of $8,000 you can purchase either of the two following streams of cash inflows:

Years Stream 1 Stream 2

4 $8,000

5 $2,000 $8,000

6 $2,000

7 $2,000

8 $2,000

$2,000

$2,000

$2,000

$2,000

Which stream of cash inflows would you prefer to receive to receive in return for your $8,000 investment? Each stream has a payback period of four years. Therefore, if payback method alone were relied on in making the decision, you would be forced to say that the streams are equally desirable. However from the point of view of the time value of money, stream 2 is much more desirable than stream 1. On the other hand, under certain conditions the payback method can be very useful. For one thing, it can help identify which investment proposals are in the "ballpark." That is, it can be used as a screening tool to help answer the question, "Should I consider this proposal further?" If a proposal does not provide a payback within some specified period, then there may be no need to consider it further. In addition, the payback period is often of great importance to new firms that are "cash poor." When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project with a high rate of return but a long payback period. The reason is that the company may

simply need a faster return of its cash investment. And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer electronics. Since products may last only a year or two, the payback period on investments must be very short. USE OF PAY BACK PERIOD 1. To test the capital budgeting decision of the company 2. To plan for future investment 3. To take corporate decisions 4. For strategic planning 5. For deciding investment opportunities