AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1av/vi. Payback method 9 / 14

Syllabus B1av/vi)

Evaluate the potential value added to an organisation arising from a specified capital investment project or portfolio using the net present value (NPV) model.

Project modelling should include explicit treatment and discussion of:

v) Risk adjusted discount rates
vi) Project duration as a measure of risk.

Payback method

This method focuses on liquidity rather than the profitability of a product. It is good for screening and for fast moving environments

The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates.

This period is some times referred to as “the time that it takes for an investment to pay for itself.”

The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.

The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period….

Formula / Equation:

  • Payback period = Investment required / Net annual cash inflow*

    *If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.

    It simply measures how long it takes the project to recover the initial cost. Obviously, the quicker the better.

Illustration

Constant cashflow scenario 

Initial cost $3.6 million
Cash in annually $700,000

What is the payback period?

  • Solution

    3,600,000 / 700,000 = 5.1429

    Take the decimal (0.1429) and multiply it by 12 to get the months - in this case 1.7 months

    So the answer is 5 years and 1.7 months

So how useful is this method?

The payback method is not a true measure of the profitability of an investment. 

Rather, it simply tells the manager how many years will be required to recover the original investment.

  1. Whole life of Project?

    Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another. 

    For example it doesn’t look at the whole life of the project

  2. Time value of money

    Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow to be received right now.

  3. Screening

    On the other hand, under certain conditions the payback method can be very useful. It can help identify which investment proposals are in the “ballpark.” 

    That is, it can be used as a screening tool to help answer the question, “Should I consider this proposal further?” If a proposal does not provide a payback within some specified period, then there may be no need to consider it further.

  4. Cash poor companies

    When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project with a high rate of return but a long payback period. 

    The reason is that the company may simply need a faster return of its cash investment.

  5. Quick changing environments

    And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer electronics. 

    Since products may last only a year or two, the payback period on investments must be very short.

In summary, the benefits are:

  1. Simple

  2. Good when the project is subject to quick change like technology. 

    This is because cashflows in the future become harder and harder to predict so recovering the money as soon as possible is vital.

  3. It minimises risk (short term projects favoured)

  4. It maximises liquidity

  5. Uses cashflows not false profits

Drawbacks

  1. the item with the quickest payback is simply that. What about afterwards, does it still do well or does it then become obsolete?

  2. It ignores the whole profitability. Also the time value of money is ignored (more of that later).

Irregular Cashflows

When the cash flows associated with an investment project changes from year to year, the simple payback formula that we outlined earlier cannot be used.

  • To understand this point consider the following data:

Cumulative
Capital out 800 -800
Cash in 100 -700
Cash in 240 -460
Cash in 200 -260
Cash in 250 -10
Cash in 120 110

When the cumulative cashflow becomes positive then this is when the initial payment has been repaid and so is the payback period

So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10 out of 120. 10/120 x 12 (number of months) = 1.

So the answer is 4 years 1 month

Extension of Payback Method:

  • The payback period is calculated by dividing the investment in a project by the net annual cash constant inflows that the project will generate.

  • If equipment is replacing old equipment then any scrap value to be received on disposal of the old equipment should be deducted from the cost of the new equipment, and only the incremental investment should be used in payback computation.