Capital Budgeting

Session 13
Pay Back Period Analysis
Question 5

• Calculate the pay back period from the following infornation

Year 4Cash flows ( in millions of Rs.)

0 (50)
1 10
2 13
3 16
4 19
5 22
Solution

Investment required = Rs. 50 Million

Year Cash Inflow (in Millions) Cumulative Cash inflow
1 10 10
2 13 23
3 16 39
4 19 58
5 22 80

• Pay back period = Apply the formula

• PBP = 3 + (11/19)
• PBP = 3+0.58
• PBP = 3.58 years
Question 6
• Calculate the payback period for the following data

Year Cash flows

0 -100
1 10
2 60
3 80
4 40
Solution

Year Cash flows Cumulative Cashflows

0 -100 -100
1 10 -90
2 60 -30
3 80 50
4 40 90

• PBP = Last year of -ve cashflow + (Amount that will make cumulative cashflow
0/next year ’s cashflow)

• Payback period = 2 + 30/80

Discounted payback period
• It refers to the period over which the investment in the project will
be recovered.
• The only difference here, is that, it considers the time value of
money, in computation.

• The discount factor would be the cost of capital.

• Identify the cost of capital, use the PVIF table to arrive
at the discounting factor, multiply with cash flows, and
apply the PBP formula.
Example 5
• Cost of the Project = Rs. 43,000
• Cost of capital/Discount factor = 10%
• Compute the Discounted pay back period
• Arrive at your acceptance/rejection decision,

if the managment wishes to consider a

maximum payback period of 3 years
Solution

Year Cashflows PVIF at 10% PV(A*B) Cumulative

(A) (b) Cashflows
1 12000 0.909 10908 10908
2 14000 0.826 11564 22472
3 16000 0.751 12016 34488
4 15000 0.683 10245 44733
5 14000 0.621 8694 53427

Pay back period = 3 + (43000-34488)/10245

PBP = 3 + 0.83
PBP = 3.83 years
This project cannot be selected since payback period is longer than
desired.
Question 7
1. Find the Pay back period for the following projects using
• Simple PBP method

• Discounted payback method at 12% cost of capital

2. Rank the projects based on their desirability

3. If the company is to choose only one project, which one would it be?

4. If the company wishes to invest in the project(s) which have a pay back
period of upto 3 years, which project(s) may be chosen?
Question 7 contd.

Year Project A (in $) Project B (in $) Project C (in $)

0 (1000) (1000) (1000)
1 250 350 500
2 250 350 500
3 250 350 500
4 250 350
5 250
6 250
7 250
8 250
9 250
10 250
Solution

Year Project A Cumulative Project B Cumulative Project C Cumulative

(in $) CF (A) (in $) (in $) CF (B) (in $) (in $) CF (C) (in $)
0 (1000) (1000) (1000)
1 250 250 350 350 500 500
2 250 300 350 700 500 1000
3 250 750 350 1050 500 1500
4 250 1000 350 1400
5 250 1250
6 250 1500
7 250 1750
8 250 2000
9 250 2250
10 250 2500
Simple PBP
• Project A = 1000/250 = 4 years (Rank III)
• Project B = Initial outlay/annual cash flow

1000/350 = 2.86 years (Rank II)

• Project C = 1000/500 = 2 years (Rank I)
2. If the company could choose only one project, it would be
Project C
3. If the company could choose all projects which could be recovered
within 3 years, it would choose
Project C and Project B
Discounted Pay back period
Year Project A Project B Project C PVIF Discounted Discounted Discounted
(in $) (in $) (in $) @ CF (A) (in CF (B) (in CF (C) (in
12% $) $) $)
0 (1000) (1000) (1000)
1 250 350 500 0.893 223.25 312.55 446.5
2 250 350 500 0.797 199.25 278.95 398.5
3 250 350 500 0.712 178 249.2 356
4 250 350 0.636 159 222.6
5 250 0.567 141.75
6 250 0.507 126.75
7 250 0.452 113
8 250 0.404 101
9 250 0.361 90.25
10 250 0.322 80.5
Year Discounted Discounted CF Disco Cumulative Cumulative Cumulative
CF (A) (B) unted Discounted Discounted Discounted
CF CF (A) CF (B) CF (C)
(C)

1 223.25 312.55 446.5 223.25 312.55 446.5

2 199.25 278.95 398.5 422.5 591.5 845
3 178 249.2 356 600.5 840.7 1201
4 159 222.6 759.5 1063.3
5 141.75 901.25
6 126.75 1028
7 113 1141
8 101 1242
9 90.25 1332.25
10 80.5 1412.75
Solution Contd.
• Payback period

• Project A = 5 + (1000 - 901.25) /126.75 = 5 + (98.75/126.75) = 5.78 years

Rank III

• Project B = 3+ (159.3/ 222.6) = 3.71 years

Rank II
• Project C = 2 + (155 / 356) = 2.44 years
Rank I

• If only one project is to be chosen, that would be

Project C

• If the organization could choose all projects which could be recovered in a

period of 3 years, the project that would be chosen would be Project C
Question 8
• XYZ LTD is considering installing an equipment costing Rs. 35,00,000. The
cost of capital is 12%.

• The project generates a uniform cash flow of 9,00,000 throughout its 8 years of
useful life.
• Compute the discounted payback period, and advice the company whether the
project may be accepted or rejected, if the company wishes to recover its
investment within a period of 5 years.