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Payback Period Method – Steps & Examples

"When will I get my money back?" This is the Payback Period.

1. Definition

The amount of time required for the Cumulative Cash Inflows to equal the Initial Cash Outflow.

  • Rule: Shorter is Better.
  • Accept: If Payback < Target Period (e.g., 3 Years).

2. Example Calculation

  • Initial Investment: ₹ 1,00,000.
  • Cash Flow Year 1: ₹ 30,000.
  • Cash Flow Year 2: ₹ 40,000.
  • Cash Flow Year 3: ₹ 60,000.

Calculation:

  1. Year 1: Recovered 30k. (Pending 70k).
  2. Year 2: Recovered 40k. (Total 70k. Pending 30k).
  3. Year 3: Cash flow is 60k. We need only 30k.
    • Time = 0.5 Years (30/60).
    • Payback Period: 2.5 Years.

3. Merits & Demerits

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4. Exam Notes: Writing the Answer

Question: "Explain Payback Period method with its limitations." (5 Marks)

Answering Strategy:

  1. Define: "Time to recover initial cost".
  2. Formula: Investment / Annual Cash Flow (If uniform).
  3. Limitations: "Ignores TVM" is the most important point to write.

Summary

  • Risk: Why do international firms use this? Because in risky countries, you want your money back FAST before the government changes rules.
  • Preliminary: It is used as a first screen filter.

Quiz Time! 🎯

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