■ . . ·. .

Procedure for calculating pay-back period:

,, . '

Pay-back period calculation is based on cash flows generated from the investme
and amoun t spent on investment proposal. Therefore we need initial investme nt Propasa
flows to calculate pay-back period. The procedure of calculating initial investment and cash1
. No. 4.15) and cash flows (see page No. 4.16) 1s • • nt(see
a~ready discussed. However it is in, Page
to note that series of cash flows generated fro~ investment proposal can be san,Portant
throughout the life of the investment proposal or 1t may vary year on year (uneven). Th:;even
based on the series of cash flow the procedure to calculate pay-back period al efore
varies: so Slightiy
Situation 1: Even Cash flows
When the cash flows generated from the investment proposal are same thought its life
. n 1s
following equatio . used to determm
. e pay-bac k peno
. d. ' the
. -
Initial investm ent
Pay- back period = - - - - - - -
Annual cashflo ws
Initial investment = Cost of asset + Opportunity Cost + Additional Working Capital
(see page No.4.15)
Annual Cash flows = Cash flow before Depreciation after Tax (CFBDAT) (see page No. 4.16)
._
Situation 2: Un-even Cash flows
When the cash flows generated from the investment proposal varies throughout its life, the
following steps should be followed.
1. Write down the years and cash flows from the investm ent proposal parallel
2. Calculate cumulative cash flows- this can ·be done by continuous adding the cash flows
generated from the invest proposal year after year till we reach initial investment.
3. In case if the cumulative cash flows exceeds initial investment, then following formula can
be used to determine exact pay-back period:

Cash flow require d to recove r initial investm e~

PBP = Year b ef ore recove r + -------=--~....:......:...::.:.....:..:......._=...::....:.....:......:::.__ _ _ _ __
Actual cash flow recived
Acceptance and Rejection criteria:
· dof the
In case of indepe ndent investm ent proposals we have to compa re the pay-back peno he
proposal with the expectation of manag ement (also called standa rd or cut-off rate). If
PBP is less than or equal to cut off rate proposal should be selected, if not rejected. In cand
\e
. . • posals 8
of mutual ly exclusive proposals, we have to compa re paybac k period of all the pro . and
·
whiche ver proposa I has a lesser PBP should be accepted. However if cut off rate is gl\lening in
if it's a mutual ly exclusive proposal then all the propos als should be evaluated keeP ,
mind the expect ation of the manag ement. 1
,I
 I
Investment Decisions
•
hInflows are equal
Wl1el1 cas
~: r . • .
~,noN4.S:
1LJ.Uit"-'r• -
ceuticals is considering investing in a new plant for manufacturing of its drugs, the
Sipla pharrn~ant is Rs.4,00,000 and the anticipated Cash flows from this plant for the next 10
t of th e P ooo p.a. Calculate the payback period.
c05 ·s Rs. 50 ,
years i
501udon:
Rs. 4,00,000
initial investment
flows p.a Rs. 50,000
cas h
·on of cash flows 10 years
ourati
Initial investment 4,00,000
pay-backperiod= Annualcashflows = 50,000 = 8 years

t' it takes 8 years for the investment proposal to pay back the amount invested.
commen ·
End Notes: . ~
_ This is an independent proJect.
1
2. For pay-back period method we need cash inflows before depreciation after tax, (CFBDAT or PBDAT) which is assumed
to be given the question.
3 Duration of cash flows refer to tenure of profits anticipated from the investment proposal.
.
4. cost of investment is the initial investment or original investment also referred as cash outlay or outflow

Celcabs taxi service has to choose one of the following mutually exclusive proposals for its

Initial Investment 9 00 000

Antici ated Cash flows after tax and before de reciation
1st ear 1 20 000 2 00 000
2nd ear 1 20 000 200,000
3rd ear 1 20 000 2 00 000
4th ear 1 20 000 2 00 000
5th ear 1 20,000 200,000
6th ear 1 20 000 2 00 000
7th ear 1 20 000
8th ear 2 00 000
1 20 000 200,000
Suggest which proposal should be accepted using pay- back period method.
Solution:

In;.·
•\lal Investment 9,00,000 10,00,000
Cashflow per annum
1,20,000 2,00,000
1st year PBP = 75
years PBP = Annual 1 ,00,000 - 5 years
lnltial investment _ 9 ,00,000 _
Annual cashflows - 1,20,000 - • Initial Investment -
cashflows - 2,00,000 -

)
4
 Financial Management

Comments: The pay-back period of Sumo and Xylo is 7.5 and 5 years respective,
should choose Xylo to invest as it has a shorter pay-back period compared to Su~- The con,Pan..
o. .,,
End Notes:
1. As this is a mutually exclusive project. therefore selection one project will lead to elimination of oth
2 . For pay-back period method we need cash inflows before depreciation after tax, (CFBDAT or PBDAT) er.
w. .
problem. hich is given ~
3. CFBDAT or PBDAT (can also termed as cash inflow after tax and before depreciation)

' fi' ILLUSTRATION4.7:

Pani-Kum-Chai, a tea restaurant is considering buying a tea vending machine for its ro .
business operations. The manageme nt has identified two mutually exclusive machines ut'.ne
.
Rs. 1,00,000 each. These machines are expected to generate following profits costing(b f
depreciation and tax). e ore

.. -~ Particulars - ~ \. Machine 'N _ -.,, ., ',~., ..,.,

Maclllaa'B'
1st year 40,000 50,000 -
2nd year
3rd year
40,000 50,000 -
40,000 50,000
4th year 40,000 50,000
5th year 40,000 50,000
With the help of above information , you are required to calc~tate payback period and advice the
manageme nt on acceptabilit y of these machines. The income tax payable the restaurant is 50%.
Solution:
,_~ ...., ~-
.l'.l
Particulars
·-.~:.....-. .-.- ..
.
>~ ', i-, ._Machine JA' Macbllll'B'. ;.,;·i

Cash flows p.a (as per the question) 40,000 50,000

Less: Deprecation = 1 00 000
= 20,000 p.a = 1 00 000
= 20,000 p.a
·
5 • ·
5

Cash flow after depreciation 20,000 p.a 30,000 p.a

Less: Tax@ 50% 10,000 p.a 15,000p.a
CFADAT or PADAT 10,000 p.a 15,000 p.~
Add: Depreciation 20,000 p.a 20,000 p.a
w
35,000p.a

---
CFBDAT or PBDAT 30,000p.a
(can also termed as cash inflow after tax and before depreciation)

PBP = Initial investment PBP-

- ~
Annual
Annualcashflows
Pay-back period _ 1.00.000 == 2 .86 years
= ;~~~ = 3.33 years
1
- 35,000

Working Note: . . attertax-

1. To compute pay-back period we need cash flows or profits derived before depreciation
(see page number):
. . Cost of asset-Scrap value
2. Deprec1at1on = L'f f th
1 eo easset
 -t>ack period of Machine 'A' and Machine
Investment Doclslona

·a·
-- --1
Is 3 .33 and 2.88 yooro r<,tJpoctlvoly.
~
8
..,e11ts= 111e P should buy Machine 'B' as it has a shorter pay-bac k porlod compared to
o."'''-18118genien
1 \e·A'·
~~I
~ ...c:
i,i~1v· . n,utuallY exclusive proposal, selection of one project will lead to ellmlnatlon of others.

1·
2·
for pa~~::
15 8
ft.S tlliS

I
riod method we need cash Inflows before depreciation after tax, (CFBDAT or PBDAT), hOwove r rhe cash
question is before depreciati on and before tax, therefore we must first calculate depreciati on
f!OwS give these from cash flows and then add back the depreciatio n.
and to,'(

depreciati on the
and deduct_ 1to deduct depreciati on and then add it back to cash flows after tax, once we deduct
essentta .
3- 11 iS cash inflow reduces and tax burden rs also reduced.
profits or f assets is not stated, it assumed the duration of cash flows itself as life.
~~o . . take the cash
4. ~ . he question states cash flows or profits before deprec1at1on and after tax. then we can directly
n and before tax.
s. 1ncase:~mpute PBP, in case if the question states that cash flows or profits are before depreciatio
ftoW5 we have to follow the above steps.
therefo-.=_r_e_ _ _--,

j 1JJJS111ATION 4.8:
L. ited, a Direct To Home (0TH) cable service provider is considering to buy a satellite
~oon ~ng Rs. 10,00,0 00 for its business operations. The estimated annual profits after
1

dish ~a\on of 12% and before tax of 50% from this satellite dish is Rs. 5,00,00 0. Calculate
deprec1
Pay-back period.

-·-
$Ollltion:
~
- ..
..
Al .
- -~ ~
,
.., .•

rs '
Cash flows (as per the question -after depreciation and before tax) 5,00,00 0
Less: Tax@ 50% (50% on 5,00,00 0) 2,50,00 0
2,50,000
Cash flows after tax
Add: Depreciation (12% on 10,00,0 00) 1,2000 0
CFBDAT or PBDAT 3,70,000
(can also termed as cash inflow after tax and before depreciation)
Pay-back period [PBP] = Initial investment = 10,00,000 = 2 • 70 years
Annual cashflows 3, 70,000

Comments: The pay-back period is 2. 70 years, i.e., the investment is fully recovered in 2. 70 years.
End Notes:
t Th'ts ·ts an independent project
~- ~Preciation is calculated on the value of the asset, as the rate of depreciation is available
PB DAT). The cash flows
· a~ePa_y-back period method we need cash inflows after tax and before depreciation, (CFATBD or
"" n in the quesr · · deduct from cash flows and then add
• •on and before tax, therefore we must first
back th ton ts after deprec1at1
e depreciation.

►
 I Rnanclal Management•

B: When cash Inflows are uneven (unequal)

I4' IU.USTRATION 4.9:

Pay-Back-Period Method -8: When cash inflows are uneven

Prestige real estate developer is considering investing in a project costing Rs. l,OO
estimated cash flows for the first, second, third and fourth year is Rs. 30,000, 40,oo~Ooo. The
and 10,000 respectively. Determine the pay-back period of the project. 20
' ,oao

..
Solution:
,
1
~~ Cuhflowl
30,000
,;::-,
I Cumulative Cash._ iCCFs). , ....
End 1st year 30- -
,.

2 40,000 End of 2 nd year 30,000+40,0QQ == ~

3 20,000 70
End of 3 rd year 70,000+20,000 == ' _.QQ
4 90
10,000 End of 4 th year 90,000+10,000 • ,
In fourth years the project pays off the ori~inal investment, therefore PBP is 4 years 1
~
00~
End Notes:
1. This is an independent project
-
2. Since the cash inflows are not equal we cannot use the equation and therefore PBP should be calculated by
add'
cash inflows till we reach original invest. The year in which we recover original investment is the PBP.
ing
3. Since the question is silent about depreciation and tax, it should be assumed cash flows are before depreciation
and
after tax (CFBDAT or PBDAT).

= I
Determine pay-back period of a project which requires a cash outlay of Rs. 10,000 and generates
cash inflows of Rs. 2,000, 4,000, 3,000 as;id 2,000 in the 1 5\ 2 nd , 3 rd and 4th year respectively.
Solution:

Cash outlay or lnltlal lnvesbnent • Rs. 10,000 ~ :~j,}~~

I Year
1
2
Clsbflows
2,000
/r,. CulllUlatlve Cash flows (CCfs)
_.,...

End 1st year 2,000

4,000 End of 2nd year 2,000 + 4,000 =6,000
I PBP f
3•
4
3,000
•2,000
End of 3rd year 6,000 + 3,000 =9,000_
End of 4th year 9,000 + 2,000 =11,000

The above table shows that at the end of the 4 th year the cumulativ e cash flows exceeds the
.
investmen t (cash outlay) of Rs. 10,000. This means by adding the cash flows of first three ye~
we recover Rs. 9 ooo
against the cash outlay of Rs. 10,000, therefore we must recover anoth er
Rs. iOOO to get back cash outlay. But in the fourth year cash inflow is Rs. 2,000 therefore pay-
back period is calculated as follows:
 Investment Decisions

+ ~ =3+0.5 =3.5 Years

P::: 3 years 2000
pS ·ng equation can be used:
or tne follow1 C h. fl .
as in ow required to recover original investment = + 1000
before recovery+-----:--- ---~~:..:..:.:..:..:.= :.::..:.:.::.::. 3
pSP :::* year Actual cash inflow received* 2000
::: +0.5 == 3.5 Years
3

dNotes:
En . . an independent project
ThlS IS
1. . the cash inflows·11 are not equal therefore we cannot use the equation and therefore PBP should be calculated by
2 since h . . I. .
· adding cash inflows t1 we reac on~i~a ,~vest. The year in which we recover original investment is the PBP. The cash
. flow in the last year exceeds the original investment, therefore the above equation is used to calculate exact PBP.
~sh inflow required to recover original investment is computed by deducting cumulative cash inflow in the year before
3
· recover from original investment. (10,000-9,000=1,000).
tax, it should be assumed that the given cash flows are before
4_ Since the question is silent about depreciation and
depreciation and after tax (CFBDAT or PBDAT).

Evershine Co. is considering the purchase of two machines 'I' and 'II' each costing Rs. 5,00,000.
The expected cash inflows are as follows:
- Year 2001 2002 2003 2004 2005
Machine I 1,50,000 2,00,000 2,50,000 1,50,000 1,00,000
Machine II 50,000 1,50,000 2,00,000 3,00,000 2,00,000
calculate Payback Period
Solution:
Caslioutl
Machine I
Year CFs CCFs Year CFs
1 1,50,000 1,50,000 1 50,000 50,000
2 2,00,000 3.,50,000 2 1,50,000 2,00,000
3 *2,50,000 · 6,bo,ooo 3 2,00,000 4,00,000
4 1,5'0,000 7,50,000 4 *3,00,000 7,00,000
5 1,00,000 8,50,000 5 2,00,000 9,00,000

p · Cash inflow required to recover original investment

BP= *Year before iecover + Actual cash inflow received*

Machine I Machine II
PBP = 2 years+~= 2+0.6 = 2.6 years · PBP = 3 years+~= 3+0.34 = 3.34 years

Comments: The pay-back period of Machine 'A' and Machine 'B' is 2. 70 and 3.97 years respectively.
The management should buy Model 'M' as it has a shorter pay-back period com pared to Model 'N'. ►
y
1~--------Fi_m_an_e1_
·a_lM_a_n_age_m_e_nt...

li ~ uz, I
Arun Ice-cream factory is considering to an automated machine for its routine operar
management has identified two models. Further detaI·1s are given
. beIow:- IOns· The

Model 'M'
Cost of machine 1,80,000
~~::..:.:.:~.:.:.:..:;::..,___ _ _ _ _ _-1--------;4:::ye=a::rs::-r------~· 3 60,000
~Esti~·m:.:..:::::at:::::e_::;.d.:.:.lij~e-:-----:--------t--------;~~r------~5years
Estimated saving:; in scrap 10,000
~~~.=..:.~ ~==:::-:~-----r----~~~--------..;1~5.ooo
Estimated savin in wa es 1,20,000 1,50,ooo
Additional cost of maintenance 10,000 12,0oo
Additional cost of supervision 5,000
8,000
Tax rate 50%
50%
Depreciation 10% lO%
You are required to calculate pay-back period and suggest the management on the acceptability
of these machines.
Solution:
Initial Investment : Model 'M': 1,80,000, Model 'N' : 3,60,000
Cash flows p.a : Rs.?
Life of Machines : Model 'M': 4 Years, Model 'N': 5 Year~
. d Initial investment
Pay- bac k peno = - - - - --
Annual cashflows
Step 1: Calculatlon of Annual cash flows

Model 'M' Midel'N'

[IJ Estimated Saving
♦ Savings on account in wages 1,20,000 1,50,000
♦ Savin s from sale of scra 10,000 15,000
{A Total Savings 1,30,000 1,65,200

♦ Cost of maintenance 12,000

10,000
♦ Savin s from sale of scrap 8,000
5,000
{B} Total Costs 15,000 20,000
Net Savin s before depreciation and tax (A-B) 1,45,000
1,15,000
Less: De reclation 10% on Cost of Machine/ Initial Investment) 18,000 36,000
Net Savin s after de reclatlon before tax 1,09,000
97,000
Less: Income Tax 50% on 97,000 and 1,09,000) 54,500
48,500
Net savln s after de reciation and tax 54,500
48,500
Add: depreciation 36,oo<l
18,000
Net Savings after tax or Cash flows (CFBDAl)
~
1~
 2: caiculation of PBP

, ,
Macllhle ..•
-
3,60,000
1tial investment 66,500 90,500
;sh floWS (CFBDAT) Pay-back period PBP = Initial investment PBP = lnitlal investment
Annual cashflows
Annual cashflows

-
-
1,80,000
ss,soo = 2 .70 years
-
-
3,60,000
90,500 = 3 .97 years

l)Nllments: The pay-back period of Machine 'M' and Machine 'N' is 2. 70 and 3.97 years
resPectively. The management should buy Model 'M' as it has a shorter pay-back period

compared to Model 'N'.

Evaluation of Pay-Back Period Method
As discussed earlier in Pay-Back method of capital budgeting decision to invest in capital
expend~ure is based on the number of years required to recover the amount invested in the

capital expenditure proposal.

Merits of Pay-back Method

1. Easy to calculate and simple to understand
2· Emphasis on early return of amount invested (liquidity)
3· Risk can be minimized by setting a lower payback period
4· Cost effective in terms of calculation
Lim·,tations of Pay-back Method

1. Ignores Time Value of Money

2· Ignores the annual cash inflows after the pay-back period
. 11
· on liquidity and ignores prof'ita bltY
3
4 o
Emph as1s . h • estment 1s. made f ro m borrowed
. verlooks the cost of capital; i.e., interest factor if t e mv
funds
5. Does not considers magnitude and timing
. . 0 f cash inflows

6- It doesnot trikP. into account salvage va Iue 0 f asset