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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) =

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

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.

Year | Rs. |
---|---|

1 | 70000 |

2 | 60000 |

3 | 55000 |

4 | 40000 |

5 | 30000 |

6 | 25000 |

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**

Year | Cash inflow (Rs.) | Cumulative cash inflow (Rs.) |
---|---|---|

1 | 70000 | 70000 |

2 | 60000 | 130000 |

3 | 55000 | 185000 |

4 | 40000 | 225000 |

5 | 30000 | 255000 |

6 | 25000 | 280000 |

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 3
^{rd}year. - 200000 – 185000 => 15000/-

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

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