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

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.

Advantages

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

• Shorter paybacks mean more attractive investments.

• Payback is easy to compute.

Disadvantage

• 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.

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

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+$\frac{15000}{40000}\Rightarrow3.375 years$