Capital budgeting is one of the main functions in finance management. This uses various techniques to assist management in selecting one project over another.
During the course of business, the management comes across various opportunities that lead to the expansion of existing projects or new projects. Ideally, management would not like to forgo any good opportunity but due to capital restraints, it has to choose between projects.
One of the techniques to implement capital budgeting is using the ‘payback period.’
The payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected.
Let us understand the payback period method with a few illustrations. Apple Limited has two project options.
The initial investment in both projects is Rs. 10,00,000.
– Project A has an even inflow of Rs. 1,00,000 every year.
– Project B has uneven cash flows as follows:
-> Year 1 – Rs. 2,00,000
-> Year 2 – Rs. 3,00,000
-> Year 3 – Rs. 4,00,000
-> Year 4 – Rs. 1,00,000
Now let us apply the payback period method to both projects.
The formula of payback period when there are even cash flows is:
Payback period= Initial investment/Net annual cash inflows
If we use the formula, Initial investment / Net annual cash inflows
then the payback period computes to –10,00,000/ 1,00,000 = 10 years
Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000)
Total outflows = 10,00,000
The formula to calculate the payback period for uneven cash flows is:
Considering the year of recovery as ‘n’.
(The period up to n-1 + cumulative cash flow in n-1 year)/Cash inflow during the nth year
Now, let us modify the cash flows of Project B and see how to get the payback period:
Say, cash inflows are:
Year 1 – Rs. 2,00,000
Year 2 – Rs. 3,00,000
Year 3 – Rs. 7,00,000
Year 4 – Rs. 1,50,000
The payback period can be calculated as follows:
|Year||Total flow ( in Lakh)||Cumulative flow|
Now to find out the payback period:
Note: In case an organization is replacing existing machinery, the inflows will be considered on an incremental basis.
The Payback Period method does not take into account the time value of money and treats all flows at par. For example, Rs.1,00,000 invested yearly to make an investment of Rs.10,00,000 over a period of 10 years may seem profitable today but the same 1,00,000 will not hold the same value ten years later.
Also, the method does not take into account the cash flows post the return of investment. Some projects may generate higher cash flows in the later life of the project.
Despite its drawbacks, the payback method is the simplest method to analyze different project/investments. It is based on the principle of liquidity. The project that provides a faster return of investment is chosen.
More liquidity means more availability of funds to invest in more projects. It is used by the management to get a quick analysis of the project. The payback method is used by individuals also to analyze investment decisions.
It is based on a very simple need to get back at least how much has been spent. In fact, even as individuals when we invest in shares, mutual funds our first question is always about the time period within which we will get back our invested money. So, it is simple and very easy to understand.