CAPITAL BUDGETING

PAYBACK PERIOD

RITIKA DUA 12BSP1743 SEC - B

What is the Payback Period?

The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is some times referred to as" the time that it takes for an investment to pay for itself.
PAYBACK INITIAL INVESTMENT = _______________ PERIODIC CASH FLOW

SIGNIFICANCE
Payback period method is the simplest way of determining the investment potential of a major project. Expressed in time, it tells a management how many months or years it will take to recover the original cash cost of the project always a vital consideration, and especially so for managements evaluating several projects at once.

Advantages and disadvantages of Payback:

Strengths of Payback: Provides an indication of a projects risk and liquidity Easy to calculate and understand
Weaknesses of Payback: Ignores TVM Ignores CFs occurring after the payback period
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APPLICATION

It can help identify which investment proposals are in the "ballpark. The payback period is often of great importance to new firms that are "cash poor. the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer electronics.

PROBLEM
York company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year. Calculate payback period. Which machine should be purchased according to payback method? Calculation: Machine A payback period= $15,000 / $5,000 = 3.0 years Machine B payback period= $12,000 / $5,000 = 2.4 years According to payback calculations, York company should purchase machine B, since it has a shorter payback period than machine A

When revenues are variable

If the revenues generated by the project are expected to vary from year to year, add the revenues expected for each succeeding year until you arrive at the total cost of the project. For example, say the revenues expected to be generated by the $100,000 project are:
YEAR 1. 2. 3. 4. REVENUE $19,000 $25,000 $30,000 $30,000 TOTAL $19,000 $44,000 $74,000 $104,000

5.

$30,000

$134,000

Thus, the project would be fully paid for in year 4, since it is in that year that the total revenue reaches the initial cost of $100,000.

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