The payback period can be defined as a length of the period required within which the investment/cost is fully recovered by the business/project. This factor plays an important role in determining whether a project should be undertaken or not. It doesn’t take into account the time value of money (TVM) but only accounts for the absolute value of cash flow (Rushinck, 1983). In the equation, it can be referred to as:
Payback period = Cost of project/investment (divided by) Annual Cash Inflow
Considering an example for payback period, let’s assume an organization invested NRs. 5,00,000 in a project. The organization projects to get a return of NRs. 1,25,000 per annum evenly throughout the project cycle. Considering that and using the formula as listed above, we get payback period to be 5,00,000/1,25,000 which equals to 4. That means the organization’s payback period is 4 yrs.
Discounted payback period is same as payback period with a slight difference that it also takes in account the time value of money (TVM). This form of calculation helps also calculate the actual risk involved in the project while considering the time factor to take in account the value of money (Bhandari, 1989). It still fails to consider the cash flow that occurs after the payback is complete even though it’s considered to be a better practice to follow this over payback period. It can be expressed in the equation as:
Discounted payback period = Actual Cash flow / (1+i) ^ n
Considering an example to calculate the discounted payback period, let’s consider that an organization made an investment of NRs. 5,00,000 while it gets 2,00,000 cash flow every year. Considering the discount rate is 12%, the calculation process for the same is as listed below (the values in the bracket are to denote that they represent a negative number):
Year (n)
Cash flow of the project (CF)
Present value (PV) = [1/(1+i)^n]
Discounted cash flow (CF*PV)
Cumulative value
0
(500000)
1
(500000)
(500000)
1
200000
0.89
178000
(322000)
2
200000
0.8
160000
(162000)
3
200000
0.71
142000
(20000)
4
200000
0.64
128000
108000
So, the discounted payback period is 3+ {20000 / (20000+108000)} = 3.16 yrs.
To decide if a project is to be taken or not, the best approach for this would be to look at the projected time horizon that the business intends to hit profitability. If we consider the payback period to be 5 yrs. and the project paid off for it within 4.5 yrs. then it’s considered that the project does generate profit within the set timeframe for the business and should be taken. However, if the project payback period is 6 yrs. but the business wants to hit profitability within 5 yrs. then the project isn’t good and shouldn’t be taken.
Thus, if the payback is positive which simply means that the project payback is less than what the business expects to enter profitability by than that’s a good signal that the project should be considered. The larger the difference (towards a lesser number), the favorable it is and should be considered but if that goes even a fraction above the company’s set target, it’s worth letting it go and not considering.
References
Bhandari, S. (1989). Discounted Payback Period – A Viable Complement to Net Present Value for Projects with Conventional Cash Flows. The Journal Of Cost Analysis, 7 (1), 43-44.
Rushinck, A. (1983). Capital Budgeting Techniques, The Payback Period, The Net Present Value, The Internal Rate of Return and their Computer Applications. Managerial Finance , 9 (1), 11-13.
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The payback period can be defined as a length of the period required within which the investment/cost is fully recovered by the business/project. This factor plays an important role in determining whether a project should be undertaken or not. It doesn’t take into account the time value of money (TVM) but only accounts for the absolute value of cash flow (Rushinck, 1983). In the equation, it can be referred to as:
Considering an example for payback period, let’s assume an organization invested NRs. 5,00,000 in a project. The organization projects to get a return of NRs. 1,25,000 per annum evenly throughout the project cycle. Considering that and using the formula as listed above, we get payback period to be 5,00,000/1,25,000 which equals to 4. That means the organization’s payback period is 4 yrs.
Discounted payback period is same as payback period with a slight difference that it also takes in account the time value of money (TVM). This form of calculation helps also calculate the actual risk involved in the project while considering the time factor to take in account the value of money (Bhandari, 1989). It still fails to consider the cash flow that occurs after the payback is complete even though it’s considered to be a better practice to follow this over payback period. It can be expressed in the equation as:
Considering an example to calculate the discounted payback period, let’s consider that an organization made an investment of NRs. 5,00,000 while it gets 2,00,000 cash flow every year. Considering the discount rate is 12%, the calculation process for the same is as listed below (the values in the bracket are to denote that they represent a negative number):
So, the discounted payback period is 3+ {20000 / (20000+108000)} = 3.16 yrs.
To decide if a project is to be taken or not, the best approach for this would be to look at the projected time horizon that the business intends to hit profitability. If we consider the payback period to be 5 yrs. and the project paid off for it within 4.5 yrs. then it’s considered that the project does generate profit within the set timeframe for the business and should be taken. However, if the project payback period is 6 yrs. but the business wants to hit profitability within 5 yrs. then the project isn’t good and shouldn’t be taken.
Thus, if the payback is positive which simply means that the project payback is less than what the business expects to enter profitability by than that’s a good signal that the project should be considered. The larger the difference (towards a lesser number), the favorable it is and should be considered but if that goes even a fraction above the company’s set target, it’s worth letting it go and not considering.
References
Bhandari, S. (1989). Discounted Payback Period – A Viable Complement to Net Present Value for Projects with Conventional Cash Flows. The Journal Of Cost Analysis, 7 (1), 43-44.
Rushinck, A. (1983). Capital Budgeting Techniques, The Payback Period, The Net Present Value, The Internal Rate of Return and their Computer Applications. Managerial Finance , 9 (1), 11-13.