Welcome to Alanis Business Academy.
I'm Matt Alanis and this is How to Calculate a Payback Period with Inconsistent Cash Flows.
In our last we learned about the payback period as well as how to calculate the payback period
assuming consistent cash flows.
For access to this video select the link above or go to the Alanis Business Academy YouTube
channel page and search for the video titled How to Calculate the Payback Period.
Unfortunately cash flows are anything but consistent, which makes the basic formula
for calculating a payback period somewhat unhelpful.
So in this video we are going to walk through how to calculate the payback period when our
expected future cash flows fluctuate from one period to the next.
The formula to calculate the payback period assuming inconsistent cash flows is A plus
the result of B divided by C.
This probably makes little sense at this point, but let me attempt to elaborate.
In this formula, A represents the last period with negative cash flow.
Essentially this is the period just before we recover our initial investment.
B represents the amount of cash that is remaining at the end of A. C represents the total amount
of cash generated in the period immediately following A. If this is still somewhat unclear
that's okay.
It will make more sense once we work through a problem.
Lets assume that we will be investing $9,000 in a project.
Since this is our investment so we include the $9,000 in parenthesis, which represents
a negative figure or cash outflow.
The Abbreviation CF stands for cash flow, and the subscript 0 indicates the period.
A period of 0 represents the present time.
Assume that based upon our calculations that we project to receive positive cash flows
of $2,000, $2,500, $3,750, and $4,500 in periods one through four respectively.
When calculating the payback period for inconsistent cash flows I find it helpful to use a two-column
approach.
The first column contains our expected cash flows in order from when we expect to receive
them.
The second column contains the remaining cash need to cover our initial investment of $9,000.
Now that we've organized our problem we simply need subtract each of our expected future
cash flows from our initial investment.
So in the first period we subtract $2,000 from $9,000 to get $7,000.
This means that after the first period we still need $7,000 to cover our initial investment.
In the second period we subtract our expected cash flows from year 2 of $2,500 from our
remaining unrecovered investment of $7,000 to get $4,500.
For year 3 we subtract expected cash flows of $3,750 from $4,500 to get $750.
At this point we only need $750 in positive cash flow to break-even and cover our startup
costs of $9,000.
Now in year 4 we expect to receive $4,500 in cash, which is much greater than the $750
needed to cover our initial investment.
Since we will experience positive cash flow in year 4, year 3 represents the last period
that we will have negative cash flow.
As a result, year 3 presents A. So already we know that our payback period is going to
be somewhere in between 3 and 4 years.
Now that we have A we need to see if we have enough information to solve this problem.
Once again, B represents the amount of cash that is remaining at the end of A. Since we
know that A is period 3 or the third year, and the corresponding cash remaining at the
end of A is $750, $750 will be used as B.
The last variable in our formula is C, which represents the total amount of cash generated
in the period immediately following A.
This is $4,500 since we expect to receive $4,500 in cash at the end of year 4, and year
4 is the period immediately following A.
At this point we simply substitute these values into their corresponding variable and solve.
Doing so gives us a payback period of 3.17 years or 3 years and 2 months if you convert
the decimal into months.
Whether this payback period is acceptable will depend in large part on the other opportunities
that we have to generate positive cash flow.
This has been How to Calculate a Payback Period with Inconsistent Cash Flows.
For questions or comments please utilize the comment box below and I'll do my best to get
back to those in a timely fashion.
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