Payback Period Method
Prerequisites
Before studying this chapter, make sure you understand:
- Capital Budgeting Process - Where evaluation fits in
- Cash Flow vs Profit - Payback uses Cash Flows, not Accounting Profit
1. Definition
The Payback Period is the length of time required for an investment to recover its initial cost. It answers the question: "How long will it take to get my money back?"
Decision Rule:
- Accept: If Payback Period < Target Period (Standard Set by Firm)
- Reject: If Payback Period > Target Period
- Ranking: Project with shorter payback period is preferred.
2. Calculation Methods
Method A: When Cash Inflows are Equal (Annuity)
If the project generates the same cash flow every year:
Payback Period = Initial Investment / Annual Cash Inflow
Problem 1 (Simple): Calculate Payback Period for a project costing ₹1,00,000 and generating annual cash inflow of ₹25,000 for 5 years.
Given:
- Initial Investment = ₹1,00,000
- Annual Cash Inflow = ₹25,000
Solution:
Payback Period = ₹1,00,000 / ₹25,000
= 4 years
Answer: The project pays back its cost in 4 years.
Method B: When Cash Inflows are Unequal
If cash flows vary each year, we use Cumulative Cash Flows.
Problem 2 (Uneven Flows): Project Cost: ₹1,00,000. Cash Inflows:
- Year 1: ₹30,000
- Year 2: ₹40,000
- Year 3: ₹50,000
- Year 4: ₹20,000
Calculate Payback Period.
Solution:
Step 1: Create Cumulative Cash Flow Table
| Year | Cash Inflow (₹) | Cumulative Cash Flow (₹) | Balance needed |
|---|---|---|---|
| 1 | 30,000 | 30,000 | 70,000 |
| 2 | 40,000 | 70,000 (30k+40k) | 30,000 |
| 3 | 50,000 | 1,20,000 (70k+50k) | (Recovered) |
Analysis:
- By end of Year 2, we recovered ₹70,000.
- We need ₹30,000 more to reach ₹1,00,000.
- In Year 3, we earn ₹50,000.
Step 2: Calculate fractional year We need ₹30,000 out of Year 3's ₹50,000 inflow. Time = 2 years + (Balance Required / Year 3 Inflow) Time = 2 + (30,000 / 50,000) Time = 2 + 0.6 years
Answer: Payback Period is 2.6 years.
3. Merits and Demerits
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Exam Pattern Questions and Answers
Question 1: "Calculate Payback Period." (4 Marks) Given:
- Investment: ₹50,000
- Annual Cash Inflows: ₹10,000, ₹15,000, ₹20,000, ₹20,000.
Solution:
- Year 1: Recovers ₹10,000 (Bal: ₹40,000)
- Year 2: Recovers +₹15,000 = Total ₹25,000 (Bal: ₹25,000)
- Year 3: Recovers +₹20,000 = Total ₹45,000 (Bal: ₹5,000)
- Year 4: Need ₹5,000 out of ₹20,000.
Fraction = 5,000 / 20,000 = 0.25 years.
Result: 3 years + 0.25 years = 3.25 years.
Question 2: "Explain why Payback Period is not a comprehensive measure of profitability." (4 Marks)
Answer: Payback period fails as a profitability measure because:
- Ignores Dividends: It stops counting as soon as investment is recovered. A project earning heavy profits in later years might be rejected in favor of a project that pays back fast but earns nothing later.
- Time Value Ignored: It doesn't account for the fact that money received earlier is more valuable.
- Focus on Liquidity: It measures liquidity (speed of return), not profitability (total return).
Quiz Time! 🎯
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