Payback Period Method of Capital Budgeting

Payback Period Method

The Payback period method of capital budgeting is popularly known as pay-off, pay out or replacement period methods also. It is the most popular and widely recognized traditional method of evaluating capital projects.

Payback period method represents the number of years required to recover the original cash outlay invested in a project. It is based on the principle that every capital expenditure pays itself back over a number of years. It attempts to measure the period of time, it takes for the original cost of a project to be recovered from the additional earnings of the project. It means where the total earnings (or net cash inflow) from investment equals the total outlay, that period is the pay-back period. The standard recoupment period is fixed the management taking into account number of considerations. In making a comparison between two or more projects, the project having the lesser number of pay-back years within the standard recoupment limit will be accepted. Suppose, if an investment earns Rs. 5000 cash proceeds in each of the first two years of its use, the payback period will be two years.

For this purpose, net cash inflow shall be calculated first in the following manner:-

Cash inflow from sales revenue                                   ……………………………………
Less operating expenses including depreciation       ……………………………………
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Net income (before tax)                                               ……………………………………

Less-Income tax                                                           …………………………………….

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Net income (after tax)                                                 ……………………………………..

Add depreciation                                                          ……………………………………..

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Net cash inflows                                                           ……………………………………..

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Note: As because depreciation does not affect the cash inflow, it shall not be taken into consideration in calculating net cash inflow. But it is an admissible deduction under income tax act. It has been deducted from the gross sale revenue and added in the Net-income (after tax).

Computation of Payback Period Method of Capital Budgeting

If annual net cash-inflows are even or constant, the pay-back period can be computed dividing cash outlay original investment) by the annual cash-inflow.

It can be put as:

Payback Period = Original Investment / Annual Cash-Inflow

If cash inflows are uneven, the calculation of pay-back period takes a cumulative form. In such case, the pay back period can be found out by adding up the figure of net cash inflows until the total is equal to the total outlay (or original investment).

Merits of Payback Period Method

The payback period method of capital budgeting is widely accepted method for evaluating the various proposals.

The merits of this method are as follows:

  1. It is easy to calculate an simple to understand. It is an improvement over the criterion of urgency.
  2. It is preferred by executives who like snap answers for the selection of the proposal.
  3. It is useful where the firm is suffering from cash deficiency. The management may like to use payback period method to emphasis those proposals which produce an early return of liquid funds. In other words, it stresses the liquidity objective.
  4. Industries which are subject to uncertainty, instability or rapid technological charges may adopt the pay-back method for a simple reason that the future uncertainty does not permit  projection of annual cash inflows beyond a limited period.  in this way, it reduces the possibility of loss through obsolescence.
  5. It is a handy device for evaluating investment proposals, where precision in estimates of profitability is not important.

Limitations of Payback Period Method

The payback period method of capital budgeting suffers from the following limitations

  1. It completely ignores the annual cash inflows after the pay-back period.
  2. The method considers only the period of a pay back. It does not consider the pattern of cash inflows, i.e., the magnitude and timing of cash inflows. For example, if two projects involve equal cash outlay and yield equal cash inflows over equal time periods, it means both proposals are equally good. But the proposal with larger cash inflows in earlier years shall be preferred over the proposal which generated larger cash inflows in later years.
  3. It overlooks the cost of capital; i.e., interest factor which is a important consideration in making sound investment decisions.
  4. The methods is delicate and rigid. A slight change in operation cost will affect the cash inflows and as such pay-back period shall also be affected.
  5. It over-emphasizes the importance of liquidity as a goal of capital expenditure decisions. The profitability of t project is completely ignored. Undermining the importune of profitability can in no way be justified.

Despite its weaknesses, the payback period method of capital budgeting is very popular in American and British industries for selecting investment proposals.

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