The number of years required for the proposal’s cumulative cash inflows to be equal to its cash outflows is called ‘Payback Period’. It is “the length of time (indicated as the number of years) to recover the initial cost of the project”.
Another way of looking it is as
“the time required for a proposal to ‘break-even’ on the net investment of the project”.
In simple words, payback period refers to the period of time in which the projects cash outflows can be recovered from the project cash inflows or investment.
Calculation of Payback Period
The calculation of payback period is carried out in different methods under two different situations as under:
Equal Annual Cash Inflows: When the revenue generated (cash inflows) during the implementation of a project remains same every year or in other words the cash inflows are in the form of an annuity, computation of the payback period is simple; it can be arrived at by dividing the ‘cash outflow’ by ‘cash inflow per annum’ (the amount of annuity).
The formula used in this situation are as under:
\[\text{Payback Period}=\frac{\text{Initial out flow of the Project}}{\text{Annual Cash In flow}}\]
For example, initial investment in a proposal involves a cash outflow of $10,00,000 and the revenue generation (cash inflow) is projected at $2,00,000 p.a. for 8 years. in this case, the payback period would be 5 years i.e., 10,00,000/2,00,000. The initial cash outflow of $10,00,000 will be fully recovered within a period of 5 years and the cash inflows accruing thereafter (6th year and onwards) is ignored.
Unequal Annual Cash Inflows: When the revenue generated (cash inflows) during the implementation of the project is different every year (not in annuity form), then the cumulative figure of annual cash inflows are taken for calculating the payback period. The concept would be clear from the following example:
For example, in a proposal, there is a cash outflow of $2,00,000 and the projected level of revenue generation (cash inflow) is not equal year after year. it is $80,000, $60,000, $40,000, $20,000 and $20,000 over next 5 years respectively. The payback period would be 4 years as illustrated below
| Year | Annual Cash Inflow ($ ) | Cumulative Cash Inflow ($) |
| 1 | 80,000 | 80,000 |
| 2 | 60,000 | 1,40,000 |
| 3 | 40,000 | 1,80,000 |
| 4 | 20,000 | 2,00,000 |
In the above example, the cash inflow exactly equals to cash-outflow at the end of 4th year, making the calculation of payback period easy. However, in those cases wherein the cumulative cash inflows do not exactly equal to the cash outflow of the project, the computation of payback period is a bit complicated. In the above case, if the cash outflow is $1,85,000 then the payback period would be calculated as follows:
The required cumulative cash inflow now would be $l,85,000. At the end of 3rd year, the cumulative cash inflow is $1,80,000. For the 4th year, the annual cash inflow is 20,000. Therefore, cash inflow of $5,000 would be required during the 4th year to make the cumulative cash inflows to be $1,85,000. The precise period required to earn a cash inflow of $5,000 during 4th year may be computed (on the assumption that the cash inflows are even throughout the year) by applying the technique of ‘‘Linear Interpolation”, i.e., the payback period is 3 years + (5,000/20,000) = 3.25 years or 3 years and 3 months. However, the above calculation is theoretical only, as the cash inflows take place at the year-end only. In such cases, the payback period of 3.25 years may be increased to next full year, i.e., 4 years
Decision Rule
The payback period, on its own is not indicative of the decision rule. It is not helpful in taking decisions unless there is a standard target period for each industry/business, with whom the computed payback period of a particular project may be compared. If the computed payback period is less than the standard target period, then the project may be considered favorable, otherwise (if the computed payback period is more than the standard target period) the proposal may be rejected. In the absence of any yardstick (standard payback period), the calculated payback period for a project remains an absolute figure with nothing to compare with, and the decision taken on its basis would be biased and illogical, lacking objectivity. However, if there is a series of proposals and ranking is required to be done in respect thereof the proposal with lowest payback period will be ranked first.
Advantages of Payback Period
Despite certain shortcomings in the ‘Payback Method’, it has an many advantage over other methods in view of the following:
- No Expertise Operation: Calculation of the payback period in respect of any project is simple and uncomplicated as compared to other advanced techniques. It is very convenient for small business houses having a limited workforce with little or no competence in respect of other advanced but complex techniques.
- Liquidity Indication: As the payback method prioritize an early cash inflow, it is the most appropriate method for an organization facing liquidity problems. During the implementation of a project, the liquidity position remains under close monitoring and a corrective measure may be taken by the organization in case it is needed.
- Lower Level of Risk: Under the payback method of capital budgeting, more emphasis is given on early cash inflows. In other words, the projects with short payback period are preferred and are considered less risky, when compared to the projects with a longer payback period. Thus, in an indirect manner, adoption of payback method results in lower level of risk (risk mitigation) for the company.
Disadvantages of Payback Period
There are certain drawbacks of using payback method for capital budgeting, some of which are as follows:
1) Overlooks Cash inflows: Under the ‘Payback Method’, cash inflow accrued after the ‘payback period’ is not given any attention. The fact that in some projects, cash inflows are substantial after the payback period is completely overlooked. This could be false and may result in discrimination against those proposals which generate substantial cash inflows during post-payback period.
2) Equal Importance to all Cash Flows: Under this method, the ‘time value of money’, is not taken into consideration. It does not discriminate between the cash inflow of certain amount at present and the cash inflow of the same amount after two years. This approach is flawed, because a certain amount received today cannot be equal to the same amount received after a gap of some years. Also the cash inflows occurring after payback period are immaterial under this method.
3) Overlooks Salvage Value: The salvage value and the total economic life of a project are totally overlooked under the payback period method. The total emphasis is on fast cash inflow so as to recover the initial investment. A project having substantial salvage value and economic life span may be kept aside in favor of a project with higher inflows in previous years. By ignoring such important aspects, this method cannot be considered as an effective tool for assessing the economic feasibility of a project. Decisions taken only on the basis of single criteria (faster and early cash inflow), avoiding other crucial aspects, may perhaps not be appropriate.
4) Method of Capital Recovery: The payback period method is more concerned with the recovery of initial investment rather than assessing the profitability and other benefits of a project. Recovery of the investment should be one of the criteria but not the sole criterion. Other aspects like profitability and other benefits likely to accrue in the long run also need to be taken into account.
Example 1: A project costs 1,00,000 and yields an annual cash inflow of 20,000 for 8 years. Calculate its payback period.
Solution: The Payback period for the project is as follows:
\[\text{Payback Period}=\frac{\text{Initial out flow of the Project}}{\text{Annual Cash In flow}}\]
\[=\frac{\text{1,00,000}}{\text{20,000}}\]
\[=\text{5 years}\]