Payback Period (Project Selection Model) Lecture # 04

Project Selection Models:

There are many project selection models which are used for analyzing different projects or
different nature. We will discuss each of them in one lecture each.

i. Payback period.
ii. Net Present Value (NPV).
iii. Internal rate of return (IRR).
iv. Cost benefits Analysis.
v. Profitability Index. Etc.

I. Payback Period:
 The time taken to recover your investment.

 The length time that will be past until the net benefits of the projects becomes
positive.

 Shorter the payback period better it is.

 More the duration of recovery will be the more will be a risk.

 Payback period can be of any time period, e.g. 2 years, 2.5 years, 3 years etc.

 Payback is calculated on the basis of estimation.

Advantages of Payback Period:

 The different advantages of Payback period are,

i. Simple calculation.

ii. Provide some information about risk investment.

Disadvantages of Payback Period:

 The disadvantages of payback period are,

Page 1
 i. Most of the firms don’t follow it.

ii. Ignore cash flow beyond payback period.

iii. Time value of money is ignored.

iv. Provide no information about profitability.

v. Provide crude information about liquidity not exact.

Formula of Payback Period:

( b−c)
PayBack Period=a+
d

Where, a= , b= ,c= ,d= .

Numerical 1:
Year Cash Flow Cumulative Cash
0 (10,000) -
1 5000 5000
2 4000 9000
3 3000 12000
4 1000 13000

(10,000−9,000)
PayBack Period=2 years+
3,000
1
= 2 years +
3
= 2 years + 0.334
= 2.334 years.

Numerical 2:
Year Cash Flow

0 (50,000)
1 15,000
2 25,000
3 30,000
4 10,000
5 5,000

Calculate payback period.

Page 2
Numerical 3:
Year Cash Flow

0 (100,000)
1 30,000
2 35,000
3 10,000
4 15,000
5 7,000
6 8,000
7 11,000

Calculate the payback period.

Page 3