Payback period
Business units, while selecting investment projects, would consider the recover of cost as the first and foremost concern, even though earning maximum profit is then ultimate goal. Payback period normally refers to the time required for recouping the initial investment in full with the help of the stream of annual cash flows generated by the project. It is also called ‘pay-out or pay off period”, expressed, as:
C
Payback period (PB) = ————
1
Where C = original coast of investment, and I = annual cash inflows.
In the case of uneven cash inflows it may be expressed as
PB = P = å (sigma)
Where X represents cash flows during periods 0,1,2,…..P represents payback period. The cash flows for the purpose of PB calculation, would be savings or earnings after payment of taxes but before depreciation. To illustrate, if a cash outlay of Rs. 30,000 is expected to yield a constant net cash flow (cash earnings minus cash expenses) of Rs. 12,000 P a for a period of 5 years, the PB is 2 ½ years (Rs. 30,000 + Rs. 12,000).
Selection criteria: Among the mutually exclusive or alternative projects whose PBs are lower than the cut-off period, the project with the shorter PB would be selected. In case there are budget constraints, the procedure would be to rank the projects in the ascending order of PBs and select the first ‘X’ number of projects which the budget provision permit. However, with a views to making the selection process more realistic, a cut-off period or minimum payback ratio could be set up and all investment proposals for which the PB is greater than this cut-off period be rejected. Payback ratio is the inverse of the payback period. For a payback period of 4 years, the payback ratio is 1/4. Thus larger the payback ratio, better the project.
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