# Explain about payback period in non-discounted cash flow technique in capital budgeting.

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Payback period allude to the amount of time it takes to reach the cost of an investment. In simple terms, it is time taken for a firm to reach breakeven point.

• A short payback period can improve the liquidity of the business quickly.

• Shorter paybacks mean more attractive investments.

• Payback is easy to compute.

• It does consider time value of money.

Formula

Pay back (even cash flows) =$\frac{investment\:required}{Net\:(annual\:cash\:inflows}$

Pay back (uneven cash flows) =

$cummulative\:cash\:flow(near\:to\:investment)\:+\:\frac{remaining\:amount\:at\:the\:start\:of\:year}{cash \:flow\:during\:the\:year}$

## Examples

• Company A is considering to purchase a new equipment to increase its production and revenue. Useful life of the equipment is 10 years and the company’s maximum desired payback is 4 years.

Initial cost of equipment: Rs. 37,500/-

Sales: Rs. 75,000/- (annual cash inflows)

Depreciation expenses: Rs. 5,000/-

Cash out flows

Cost of ingredients: Rs. 45,000/-

Salaries expenses: Rs. 13,500/-

Maintenance: Rs. 1,500/-

strong

The solution is mentioned below −

Pay back (even cash flows) =$\frac{investment\:required}{Net\:annual\:cash\:inflow}$

Step 1 −Compute net annual cash flow=> 75000-(45000+13500+1500) => Rs.15000/-

Step 2 − $\frac{cost\:of\:equipment}{Step 1}\Rightarrow\frac{37500}{15000}\Rightarrow2.5 years$

In this problem, depreciation is a non-cash expenses. So, it is ignored while calculating payback.

• An investment of Rs. 2,00,000 is expected to generate the following cash inflow is 6 years.

YearRs.
170000
260000
355000
440000
530000
625000

Let us compute payback now.

Pay back (uneven cash flows) =

$cummulative\:cash\:flow(near\:to\:investment)\:+\:\frac{remaining\:amount\:at\:the\:start\:of\:year}{cash \:flow\:during\:the\:year}$

Solution

YearCash inflow (Rs.)Cumulative cash inflow (Rs.)
17000070000
260000130000
355000185000
440000225000
530000255000
625000280000

Unrecovered investment at start of 4th year => initial cost – cumulative cash inflow at the end of 3rd year.

• Initial cost – cumulative cash inflow at the end of 3rd year.
• 200000 – 185000 => 15000/-

Payback period =3+$\frac{15000}{40000}\Rightarrow3.375 years$