- Trending Categories
- Data Structure
- Networking
- RDBMS
- Operating System
- Java
- iOS
- HTML
- CSS
- Android
- Python
- C Programming
- C++
- C#
- MongoDB
- MySQL
- Javascript
- PHP

- Selected Reading
- UPSC IAS Exams Notes
- Developer's Best Practices
- Questions and Answers
- Effective Resume Writing
- HR Interview Questions
- Computer Glossary
- Who is Who

# 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.

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

- Related Questions & Answers
- Define NPV in discounted cash flow technique in capital budgeting.
- What is Profitability index in discounted cash flow technique in capital budgeting?
- What is Accounting Rate of Return in discounted cash flow technique in capital budgeting?
- What is Payback Period in Capital Budgeting?
- What is Discounted Payback Period?
- Explain discounted cash flow analysis in merger and acquisitions
- What is Capital Cash Flow method?
- Explain about cash flows in financial management.
- How to use Capital Cash Flow in valuing a project?
- Explain free cash flow to firm (FCFF)
- Explain about venture capital in financial management.
- Differentiate between cash flow and free cash flow.
- Why is Discounted Cash Flow (DCF) Method not suitable for valuing stock options?
- How to use Cash Flow Approach for Capital Structure Analysis?
- How does Working Capital affect the Cash Flow from Operations?