Payback period is the number of years required to recover the original cash outlay invested in a project.
nIf the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:
Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is
(50000/12500) = 4 years
nUnequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.
nSuppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
nThe project would be accepted if its payback period is less than the maximum or standard paybackperiod(CUT OFF) set by management.
nAs a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.
As a method Payback
Has Certain virtues:
–Cash flows after payback
–Cash flows ignored
–Cash flow patterns
–Inconsistent with shareholder value