Payback is the length of time it takes
to recover the cost of the initial capital outlay.
All else being equal, a shorter payback period is preferred.
We will look at two different scenarios for capital project
payback--
an example where the cash inflows are equal
amounts and an example where the cash
inflows are unequal amounts.
The formula for calculating payback with equal net cash
inflows couldn't be easier.
It is the amount invested divided
by the expected annual net cash inflows.
Let's look at an example.
The Fine Young Cannibals make a $100,000 investment
in recording equipment which will save them
$25,000 per year.
So the $100,000 of initial investment divided by 25,000
of net annual savings is 4.
It will take four years to recover the initial investment.
For payback with unequal net cash inflows,
there is no formula.
We need to accumulate net cash inflows
until the amount of investment is recovered.
So let's look at the example.
The Fine Young Cannibals make a $100,000 investment
in recording equipment, which will save them
the following each year--
$30,000, $40,000, $30,000, and $25,000.
So the way I determine payback is to make a table like this.
I made this one in Excel.
I list the years, the amount of initial investment,
which happens in year zero, or in other words,
at the beginning, the yearly net cash inflows,
and the accumulated net cash flows.
In this example, I recover $100,000 in year three,
so payback is three years.
Often, the unequal cash flows will pay back
during part of a year rather than at the end.
When this happens, we need to use this formula
for the partial year.
It is the remaining unrecovered amount
divided by the expected cash inflow in the next year.
In this updated example, I recovered
$110,000 of initial investment some time during year four.
Using the formula, I have $10,000 still unrecovered
after year three and expect to recover $25,000 in year four.
So $10,000 divided by $25,000 is 0.4.
Payback is three full years plus 0.4 of the next year.
Or in other words, 3.4 years.
The decision guideline for the payback method is pretty basic.
Investments, or capital projects,
with shorter payback periods are more desirable,
all things being equal.
Let's conclude with some criticisms
of the payback method.
The first problem is that it focuses only
on time, not on profitability.
We have no idea how profitable any of the projects
were in the examples I've shown.
Also, it considers only the cash flows
that occur during the payback period.
Again, in the examples, it was possible
that net cash inflows could have gone on for many years,
but that isn't considered with this method.
Finally, it doesn't consider the time value of money.
It assumes that the value of money today
and the value of future cash inflows are the same.
They aren't.
If you're wondering why that is, watch the next video.