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Discussion on: Payback Period and Discounted Payback Period

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Historically, the payback period method has been used as a formal method to evaluate project’s riskiness since positive cash flow deals how fast an investment can be recovered. Quite simply, the payback period method calculate the number of years required for positive cash flows to just equal the total initial investment (I) (Hoskins & Mumey, 1979). Hence, the method screens the projects on the basis of how long it takes for net receipts to equal investment. But it does not for saving after payback period generated by the project. A low value payback period is considered for the better project when choosing among mutually exclusive projects.

On the basis of way to compute, pay­back period method can be classified into two types

Simple Payback Period

Simple payback indicates the requirement time period to break even on an investment without considering time value of money. It doesn’t consider the cash flow amount after payback period.

It is compute as follows:

Simple payback Period (SP) = Initial Investment / Expected savings or Net cash inflow per period

Advantage:

  • Easy to calculate
  • It is interpret in terms of time.
  • It doesn’t require any assumption about the project in terms of timing like useful life, interest rate etc.

Disadvantage:

  • Fails to measure profitability i.e. no profit is made during the payback period.
  • It ignores time value of money.
  • It does not account for savings after the payback period.

Example: Simple payback periods from the given cash flows of project when MARR is 20%

End of period Net cash flow (Rs) Cumulative cash flow (Rs)
0 -25000 -25000
1 +8000 -17000
2 +8000 -9000
3 +8000 -1000
4 +8000 +7000
5 +13000 +20000

Here, cumulative cash flow turns to positive in period 4. Therefore, payback periods lies between period 3 and 4. By interpolating we get payback period is
= 3 + 1000/8000
= 3.125 periods.

Discounted Payback period

This method includes time value money for determining payback period. Hence, it is defined as the number of years required to recover the investment from discounting cash flow i.e. considering time value of money.

Steps:

  • Discount each of the future cash flows into present.
  • Calculate the required number of years to recapture initial investment.

It should be remember that, it can overcome one major shortcoming of simple payback period that is considering of time value of money but all other shortcomings are still found in this method.

Example: Discounted payback periods from the given cash flows of a project when MARR is 20%

End of period Net Cash flow (Rs.) Discounted cash flow into present (Rs.) @20% Cumulative Cash flow (Rs.)
0 -25000 -25000 -25000
1 +8000 6667 -18333
2 +8000 5556 -12777
3 +8000 4630 -8147
4 +8000 3858 -4289
5 +13000 5224 +935

Here, the cumulative cash flow turns to positive in period 5. Therefore, payback period lies between period 4 and 5. By interpolating, we get the required payback period is

= 4 + 4289/5224
= 4.82 periods.

Analysis: It’s most commonly used as a "reality check” before moving on to other ROI calculations. "The best use of payback, in my opinion,” says Frank Knight (1921), "is to quickly check on the numbers before deciding whether to investigate the investment further.” Payback is often used to talk about government projects or relatively risky projects that are capital intensive. "Industrial and manufacturing companies tend to like payback,” says Knight. One of the fundamental flaws in the method is you’re not taking into account the time value of money, translating future cash flows into today’s dollars. It’s like comparing "cantaloupes to cabbages, because dollars today have a different value than dollars down the road,” says Knight.

The capital project could involve buying a new plant or building or buying a new or replacement piece of equipment. Most firms set a cut-off payback period, for example, three years depending on their business. Some organization have four years depending on business types either it is manufacturing industry and hydro business (Gallo, 2016). In other words, in this example, if the payback comes in under three years, the firm would purchase the asset or invest in the project. If the payback took four years, it would not, because it exceeds the firm’s target of a three-year payback period. From above example our payback is 3.125 and company threshold is 3 years only then the proposed plan is rejected to investment.

References
Frank, K. (1993). Risk, Uncertainty, and Profit. Boston: Houghton Mifflin.

Gallo, A. (2016). A Refresher on Payback Method. Harvard Business Review.

Hoskins, C., & Mumey, G. (1979). THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION. Eng. Economist 25(l):, 59 - 63.