Payback Period

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Corporate Finance - Payback Period

Payback Period
Payback period (PP) is the number of years it takes for a company to recover its original investment in a project, when net cash
flow equals zero. In the calculation of the payback period, the cash flows of the project must first be estimated. The payback
period is then a simple calculation.
Formula 11.10

PP = years full recovery + unrecovered cost at beginning of last year

cash flow in last year
The shorter the payback period of a project, the more attractive the project will be to management. In addition,
management typically establishes a maximum payback period that a potential project must meet. When two projects
are compared, the project that meets the maximum payback period and has the shortest payback period is the project
to be accepted. It is a simplistic measure, not taking into account the time value of money, but it is a good measure of a
project's riskiness.
Look Out!

For payback periods, the decision rules are as follows:

If payback period < the minimum payback, accept the project

If payback period > the minimum payback, reject the project

Example: Payback Period

Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity to its existing
plant. The company estimates the cash flows for each machine to be as follows:
Figure 11.2: Expected after-tax cash flows for the new machines

Calculate the payback period of the two machines using the above cash flows and decide which new machine Newco
should accept. Assume the maximum payback period the company establishes is five years.
Answer:
First it would be helpful to determine cumulative cash flow for the machine project. This is done in the following
table:
Figure 11.3: Cumulative cash flows for Machine A and Machine B

Payback period for Machine A = 4 + 1,000 = 4.67

1,500
Payback period for Machine B = 2 + 0 = 2.00
0
Both machines meet the company's maximum payback period. Machine B, however, has the shortest payback period
and is the project Newco should accept.
2. Discounted Payback Period
The one issue we mentioned with the payback period is that it does not take into account the time value of money, but
the discounted payback period does.The discounted payback period discounts each of the estimated cash flows and
then determines the payback period from those discounted flows.
Example: discounted payback period
Using our last example above, determine the discounted payback period for Machine A and Machine B, and determine
which project Newco should accept. As calculated previously, Newco's cost of capital is 8.4%.
Figure 11.4: Discounted cash flows for Machine A and Machine B

Answer:
Payback period for Machine A = 5 + 147 = 5.24
616
Payback period for Machine B = 2 + 262 = 2.22
1178
Machine A now violates management's maximum payback period of five years and should thus be rejected.
Machine B meets management's maximum payback period of five years and has the shortest payback period.

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