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What Is the Pay-Back Period?
If a machine costs $8,000 to purchase at the start of first year , then generates net cash inflows from the sales of products made by the machine of $ 8,000 in first year and $5,000 in secondyear then it would recoup the initial cash outlay in the first year
Payback Period + (A - 1) = Cost - Cumulative Cash Flow % ( A - 1) Cash FlowA
Where:
A= Year in which the cumulative cash flows from investment exceed the initial cost
A-1 =The year prior to A.
Cash FlowA= Net cash flow in Year A
Cumulative Cash Flow( A - 1)= Cumulative Cash Flows from investment at the end of the Year (A - 1).
Cost= The initial cost of investment
Payback Period is the duration needed to recover the cost of investment.
All other things equal, the investment with a shorter payback period should be preferred.
Long payback periods increase the riskiness of investments because the uncertainty increases with the length of time.
Consider the following two investments.
§ Investment A has NPV of $2,000,000 and payback period of 3 years.
§ Investment B has NPV of $2,100,000 and payback period of 15 years.
Now, even though Investment B is slightly more profitable, Investment A is probably the better bargain because of the fact that a lot could go wrong in the 12 additional years required for investment B to recover its cost. However, There are several factors that create uncertainty over a period of time such as changes in macro-economic factors, technology, legislation, competitive environment, consumer tastes, political environment and tax laws, all potentially affecting the feasibility of investments.
What Is a Payback Period?
The PBP calculation is tool of a new investment for organisation or financer to know the return back investment money in how many years. This tools used for every new project small or large to know the return back the investment money.
The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income.
When an organisation is invested in two or more investments/projects, the Management and investors will try to know by compare the projects to see which one has the shorter PBP& which Projects with longer PBP are usually associated with higher risk too.
The entire payback period system is depend to the Cash Flow, The Cash flow also became Postive / Negative based on the projection Income of future. While determining the payback period for both the circumstances (Negative/ Positive), the different formula/ technique/ method is to be adopted.
Lets Talk About:
Positive Cash Flow for PBP:
This is prepared with very positive attitude and expected return/income in future.
i) Positive cash flows mean that the investment is expected to bring in income that is constant each year.
ii) The first investment is for a new machine that will produce one of your company's products more efficiently and will bring in the same income each month based on the organization's steady production of that item.
iii) The cost of Projecte is $1,, and it is expected to bring the net cash flow of $, per Annum for the years of the project's useful life. The Payback period is Formula: Cost of project/ net Cash flow per annum, such as $1,,/ $,= years payback period.
Negative Cash Flow for PBP:
The Negative cash flows occur when the annual cash flows are not the same order as Positive cash Flow each year.
Under these circumstances, the formula that we used before will not work but being the wise Investor it is required to prepare a project report with consider all expected business by projecting the future year of net cash flow for such project to Pay back.
how to figure out the PBP for this project.
Negative Cash Flows Formula:
Cumulative cash flows are the running total added to the initial investment. Remember that the initial investment is a cash outflow and is shown as a negative number.
Year zero is the first year that shows the amount of the initial investment, and each year afterwards has income that is added to find the cumulative net cash flow for that year.
We see that in the chart, it takes over.5 Years to pay back the initial investment.
Year
Net Cash Flow
Cumlative Cash Flow
PBP( in Year)
0
-1,,
-1,,
1
7,
-,
2
8,
-,
3
,
-,
4
9,
-,
5
,
-,
6
,
-,
7
9,
-,
8
8,
-,
9
7,
-,
,
-6,
0.5
,
6,
6,
6,
TOTAL PAYBACK PERIOD
.5
,
It also described above by taking the last negative cumulative cash flow and dividing it by the expected net cash flow for the next year.
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is:
Payback Period =Initial Investment / Cash Inflow per Period
Payback period, as its name suggests, is the time period required to recover initial capital expenditure for an investment.
Please note that the formula (initial investment / cash inflow per period) is useful for projects that produce equal periodic cash inflows throughout their lives.
However, in reality, periodic cash flows differ significantly making impossible to logically apply above formula. e.g payback period of a four-years project that requires $140m initial capital outlay and yields $10, 30, 40 & 120m in consecutive 4 years would be 3.5 years calculated as follows:
10+30+40 = 80m recovered in 3 years
Remaining 60m is estimated to be recovered in half a year on pro rata basis (60m/120m = 0.5year)
Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point. [1] For example, a $1000 investment made at the start of year 1 which returned $500 at the end of year 1 and year 2 respectively would have a two-year payback period. Payback period is usually expressed in yrting from investment year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below.2=3 The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.
Thanks For inviting and i agree with Saiyid Maududi answer
Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point
The pay back period is the period end of which entire investment recovered.
Pay Back Period = Cost of Investment / annual Cash Inflows
