Pay-back Period Method

12 Key excerpts on "Pay-back Period Method"

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  Managerial Accounting

  • James Jiambalvo(Author)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  Two of these approaches, the payback period method and the accounting rate of return method, are discussed in this section. As you will see, both of these methods have significant limitations in comparison to net present value and internal rate of return. Payback Period Method The payback period is the length of time it takes to recover the initial cost of an invest- ment. Thus, if an investment opportunity costs $1,000 and yields cash flows of $500 per year, it has a payback period of 2 years. If an investment costs $1,000 and yields cash flows of $300 per year, it has a payback period of 3⅓ years. All else being equal, a company would like to have projects with short payback periods. One approach to using the payback method is to accept investment projects that have a payback period less than some specified requirement. However, this can lead to extremely poor decisions. For example, suppose a company has two investment oppor- tunities, both costing $1,000. The first investment yields cash flows of $500 per year for 3 years and has a payback period of 2 years. The second investment yields no cash flows in the first 2 years but has cash flows of $1,000 in the third year and $4,000 in the fourth year. Thus, it has a payback period of 3 years. Obviously, the second investment is preferable. However, if the company has a 2-year payback requirement, it will select the first investment and reject the second. The problem is that the payback LEARNING OBJECTIVE 3 Use the payback period and the accounting rate of return methods to evaluate investment opportunities, and explain why managers may concentrate erro- neously on the short-run profitability of invest- ments rather than their net present values. Simplified Approaches to Capital Budgeting 345 method does not take into account the total stream of cash flows related to an investment. It only considers the stream of cash flows up to the time the investment is paid back.

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  Strategic Finance for Criminal Justice Organizations

  • Daniel Adrian Doss, William H. Sumrall III, Don W. Jones(Authors)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  The payback time method represents the amount of monies that represent the initial costs of the capital investment versus the mathematical summation of each of the annual cash flows, which are anticipated during the duration of the lifetime of the capital investment, until a payback time threshold is manifested. Therefore, the payback time method represents a ratio between initial costs of the capital investment and the summation of necessary cash flows, annually, until the payback period is demonstrated.

  The payback time method is expressed as the summation of the costs of investment divided by these annual amounts. Because time values cannot be expressed as a negative number, the absolute value of the outcome of the payback time method represents the amount of time that is required to compensate financially for the expended costs of investment regarding a capital initiative.

  The following variables are used to represent the entities that exist within the mathematical relationships of the payback time method:

  T Time required for payback to occur

  P Period currently examined within the current payback time method iteration

  A P Annual cash flow value

  V I Value amount of the initial funding

  E R Financial effect of a partial year (if any)

  T P Partial year period (if any)

  With respect to an overall period of years, the following expression represents the mathematical relationships among the variables that comprise the payback time method:

  Note: The value of the variable P does not exceed the time required for the threshold value to occur.

  Further, with respect to a partial period, which is indicative of a period that represents a partial year, the following expression represents the mathematical relationships among the variables that comprise the payback time method:

  Note: The value of the variable P does not exceed the time required for the threshold value to occur.

  The concept of the payback time method is fairly straightforward because it is merely the consideration of a ratio between the amounts of financial funds invested versus the amounts of annual cash flows that are necessary to surpass a threshold of compensation regarding the investment costs of the capital initiative. The following section considers the basic premise of the payback time method.

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  Information Technology Investment

  Decision-Making Methodology

  • Marc J Schniederjans, Jamie L Hamaker;Ashlyn M Schniederjans;;(Authors)
  • 2004(Publication Date)
  • WSPC

    (Publisher)

  The payback period is the amount of time required to recover the cost of the initial investment. The cutoffperiod is the pre- specified length of time in which an investment must recover its initial investment to be considered the best alternative. The decision rule for the payback period methodology is fairly simple. If the payback period is shorter than or equal to the cutoff period, make the investment; if it is not, do not make the investment. When selecting one or more alternatives among a set, the investment or investments associated with payback periods less than or equal to the cutoff period are considered to be the best and should be undertaken. Payback period methodology involves selecting a suitable cutoff period and determining the payback period for each alternative investment. Most firms and banking officials are aware of ideal Basic Financial Methods 89 benchmarks of payback periods. Each type of alternative investment in IT has its own ideal payback period. Equipment like PC’s, for example, would have to have a very short payback period, usually two years, in order to justify the investment due to their relative speedy obsolescence time period. Let’s illustrate the use of the payback period methodology with an example. Suppose that an organization must select one computer system from a set of two alternative systems. Table 5 presents the initial investment and cash flows associated with the two alternative investments. Let’s assume that it has been determined that the cutoff period is 2 years. The alternative IT investment that recovers the initial cost in 2 years or less is the best alternative according to this methodology and the specified parameter.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  Computing the Payback Period To compute the payback period, we need to know the project’s cost and estimate its future net cash flows. The net cash flows and the project cost are the same values that we used to compute the NPV calculations. The payback (PB) equation can be expressed as follows: = + P B Years before cost recovery Remaining cost to recover Cash flow during the year (10.2) Exhibit 10.5 shows the net cash flows (row 1) and cumulative net cash flows (row 2) for a proposed capital project with an initial cost of €70 000. The payback period calculation for our example is: = + = + − = + = P B Years before cost recovery Remaining cost to recover Cash flow during the year 2 years €70 000 €60 000 €20 000 2 years 0.5 2.5 years We will now look at this calculation in more detail. Note in Exhibit 10.5 that the firm recovers cash flows of €30 000 in the first year and €30 000 in the second year, for a total of €60 000 over the two years. During the third year, the firm needs to recover only €10 000 (€70 000 €60 000) − to pay back the full cost of the project. The third-year cash flow is €20 000, so we will have to wait 0.5 year (€10 000/€20 000) to recover the final amount. Thus, the payback period for this project is 2.5 years (2 0.5) + . The idea behind the payback period method is simple: the shorter the payback period, the faster the firm gets its money back and the more desirable the project. However, there is no economic rationale that links the payback method to shareholder value maximisation. Firms that use the payback method accept all projects having a payback period under some threshold and reject those with a payback period over this threshold. If a firm has a number of projects that are mutually exclusive, the projects are selected in order of their payback rank: projects with the shortest payback period are selected first.

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  Engineering Economics for Aviation and Aerospace

  • Bijan Vasigh, Javad Gorjidooz(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  Break-even analysis is a decision-making technique often used to determine the break-even point quantity (value of a parameter) for a single project that makes total costs equal to total revenue resulting in a zero profit. Therefore, the annual usage rate (annual production or consumption units) must be equal to or greater than the break-even quantity to make the project economically acceptable. Break-even analysis may also be applied to two mutually exclusive alternatives, for instance, buy decision versus make decision. In comparing the alternatives, the intention is to determine the indifference point between the two alternatives. In other words, at break-even point, both alternatives become equally attractive. With larger or smaller parameter values, one or the other alternative becomes more attractive.

  Some companies have a required time period as a policy for recovering their investments. Payback period is a simple technique to quickly determine the time period needed to recover the initial investment or the first cost. Conventional payback period assumes that the interest rate is equal to zero. Discounted payback period utilizes the minimum acceptable rate of return.

  The focus of this chapter is to empower readers to use the break-even analysis technique to evaluate single projects and select among mutually exclusive alternatives. This chapter also aims to enable readers to quickly utilize the conventional and discounted payback periods to determine the viability of single projects, select the optimal project among mutually exclusive alternatives, and select economically justified independent projects.

  The following sections briefly address the calculation of break-even point for single projects, the criteria for accepting or rejecting projects, and the comparison and selection process between two mutually exclusive projects. In addition, this chapter describes calculation of both conventional and discounted payback periods.

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  Applied Corporate Finance

  • Aswath Damodaran(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Payback The payback on a project is a measure of how quickly the cash flows generated by the project cover the initial investment. Consider a project that has the following cash flows: Cash Flow $300 $400 $500 $600 Investment $1,000 The payback on this project is between two and three years and can be approximated, based on the cash flows to be 2.6 years. 194 Chapter 5 MEASURING RETURN ON INVESTMENTS Table 5.12 P AYBACK FOR B OOKSCAPE O NLINE Year Cash Flow in Year Cumulated Cash Flow 0 − $1,150,000 1 $340,000 − $810,000 2 $415,000 − $395,000 3 $446,500 $51,500 4 $720,730 $772,230 As with the other measures, the payback can be estimated either for all investors in the project or just for the equity investors. To estimate the payback for the entire firm, the free cash flows to the firm are added up until they cover the total initial investment. To estimate payback just for the equity investors, the free cash flows to equity are cumulated until they cover the initial equity investment in the project. I LLUSTRATION 5.10 Estimating Payback for the Bookscape Online Service This example estimates the payback from the viewpoint of the firm, using the Bookscape online service cash flows estimated in Illustration 5.4. Table 5.12 summarizes the annual cash flows and their cumulated value. The initial investment of $1.15 million is covered sometime in the third year, leading to a payback of between two and three years. If we assume that cash flows occur uniformly over the course of the year: Payback for project = 2 + ( $395 , 000 ∕ $446 , 500 ) = 2 . 88 years Using Payback in Decision Making Although it is uncommon for firms to make investment decisions based solely on the payback, surveys suggest that some businesses do in fact use payback as their primary decision mechanism. In those situations where payback is used as the primary criterion for accepting or rejecting projects, a maximum acceptable payback period is typically set.

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  Making the Compelling Business Case

  Decision-Making Techniques for Successful Business Growth

  • W. Messner(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  NPV is always (!) the most appropriate approach to calculating business cases; Sections 2.3 – 2.6 describe the most common alternative methods, highlight their weaknesses (and strengths, if at all), and explain why they are always (!) inferior to the NPV method when making decisions on investment propositions. Sometimes they are indeed appropriate to use, but the same decision can always (!) be reached with the much more straightforward NPV method. Chapter 5 is dedicated to the practical application of the NPV method. 2.3 PAYBACK AND DISCOUNTED PAYBACK METHOD Some corporations require the initial investment on any of their projects (i.e. the cash outflow in year zero) to be recoverable within a specified period. Statements by executives like “The costs need to be recovered within the same financial year” or “The investment needs to show a leverage within the same quarter” are telling signs of this pre-set investment parameter. Other companies tend to compare and judge investment alternatives on how rapidly they can recover the cash outflow, obviously trying to impress shareholders and other stakeholders with quick results. And again, some business managers try to get their pet projects approved by promising “immediate returns” to their superiors. Such requirements and approaches all refer to the payback period, which can be found by calculating the time it takes before the cumulative forecasted net cash flows from year one onwards equal the initial investment in year zero. In simple terms, the payback period is the time it takes to recover the initial spending on the investment. Figure 2.7 looks at three different mutually exclusive project alternatives. All three projects initially invest $470,000, but differ in their cash flows in subsequent years. The first project reaps a positive cash flow of $25,000 in the first four years and then decommissions the investment with a positive cash flow of $470,000 in the fifth year

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  Finance for IT Decision Makers

  A practical handbook

  • Michael Blackstaff(Author)
  • 2012(Publication Date)
  • BCS, The Chartered Institute for IT

    (Publisher)

  Table 6.1 .

  Figure 6.1 shows the now familiar diagram of this investment, with the break-even point marked on it.

  Some organisations use payback as a filter in order to weed out investments not regarded as worthy of further consideration. This is often done where more investment proposals are put forward than there are funds with which to undertake them. If a proposal passes the payback test by breaking even within the company’s current ‘hurdle period’, then it may be subjected to some or all of the other evaluation methods. If not, it may be rejected out of hand. As an example, if investments of similar type, size and risk have typically paid back within 15 months, then ours, with a payback of nearly 30 months would not stand much of a chance unless the payback could be substantially improved. The simple expedient of using leasing to spread the payments can often bring forward the payback of an investment.

  PAYBACK AND RISK

  The payback question – how soon will we get our money back? – is one that we as individuals would ask almost instinctively if invited by a friend to put money into some ‘little earner’ that they had in mind, such as (perhaps) producing and selling the new jelly-slicer that the world has been waiting for. Why is this? The reason is associated with the idea of risk and uncertainty. Most of us, if we have any spare cash, put it into something that we believe to be reasonably safe. Most of us are, as the jargon has it, risk-averse.

  In the previous chapter we looked at an example that categorised IT investments into three levels of project risk. A straight technology replacement proposal, with new but proven technology from the same trusted supplier, and with no change to existing applications, might be regarded as low risk. Undertaking a new application, one that is new for us but that has been available for years and used successfully by many organisations like ours, might be regarded as medium risk but still reasonably safe. However, what about being one of the first organisations to invest in a completely new application, using new technology and never before tried in our industry? That is perhaps rather closer to the jelly-slicer in terms of risk.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Note in Exhibit 10.5 that the firm recov- ers cash flows of $30,000 in the first year and $30,000 in the second year, for a total of $60,000 over the two years. During the third year, the firm needs to recover only $10,000 ($70,000 − $60,000 = $10,000) to pay back the full cost of the project. The third-year cash flow is $20,000. Assuming that the cash flows arrive evenly throughout the year, we will have to wait 0.5 year ($10,000/$20,000 = 0.5) to recover the final amount. Thus, the payback period for this project is 2.5 years (2 years + 0.5 year = 2.5 years). Exhibit 10.5 shows the payback period cash flows and calculations. payback period the length of time required to recover a project’s initial cost 10.3 The Payback Period EXHIBIT 10.5 Payback Period Cash Flows and Calculations The exhibit shows the net and cumulative net cash flows for a proposed capital project with an initial cost of $70,000. The cash flow data are used to compute the payback period, which is 2.5 years. 0 2 1 4 3 Year Time line Net cash flow (NCF) −$70,000 $30,000 $30,000 $20,000 $15,000 Cumulative NCF −$70,000 −$40,000 −$10,000 $10,000 $25,000 10.3 The Payback Period 10-15 The idea behind the payback period method is simple: the shorter the payback period, the faster the firm gets its money back and the more desirable the project. However, there is no economic rationale that links the payback method to stockholder value maximization. Firms that use the payback method accept all projects having a payback period under some threshold and reject those with a payback period over this threshold. If a firm has a number of projects that are mutually exclusive, the projects are selected in order of their payback rank: projects with the shortest payback period are selected first. Learning by Doing Application 10.2 illustrates additional payback calculations. How the Payback Period Performs We have worked through some simple examples of how the payback period is computed.

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  Petroleum Economics and Engineering

  • Hussein K. Abdel-Aal, Mohammed A. Alsahlawi(Authors)
  • 2013(Publication Date)
  • CRC Press

    (Publisher)

  It is particularly good as a “screening” means relative to various capital pro-posals. For example, expenditures for units may not be made by an oil refin-ery unless the payback period is no longer than 3 years. On the other hand, the proposed purchase of a subsidiary may not be considered further unless the payback period is 5 years or less. But payback has its drawbacks. For example, payback ignores the actual useful length of life of a project. Also, no calculation of income beyond the payback period is made. Payback is not a direct measure of earning power, so the payback method can lead to decisions that are really not in the best interests of an oil company. Example 6.2 Calculate the payout period for the two alternatives of capital expendi-tures involving an investment of $2 million each for a sulfur removal plant, as given in Table 6.2. The life of project 1 and project 2 is 6 and 10 years, respectively. TABLE 6.2 Cash Flow for the Sulfur Removal Plant (Example 6.2) Cash Flow (S) Year Project 1 Project 2 0 2,000,000 2,000,000 1 1,500,000 200,000 2 500,000 300,000 3 400,000 400,000 4 350,000 400,000 5 250,000 400,000 6 200,000 400,000 7 100,000 400,000 8 — 400,000 9 — 400,000 10 — 400,000 Cash flow $3,300,000 $3,700,000 Annual cash flow ($/yr) 471,429 370,000 P.P (yr) 4.24 5.41 124 Petroleum Economics and Engineering SOLUTION From the cash flow given in payout Table 6.2, the payout period (P.P.) is calculated as follows: (P.P)1 = 2 × 10 6 /471,429 = 4.24 years where $471,429 is the average annual cash flow. (P.P.)2 = 2 × 106/370,000 = 5.41 years where $370,000 is the average annual cash flow. $ – $ 500,000.00 $ 1,000,000.00 $ 1,500,000.00 $ 2,000,000.00 $ 2,500,000.00 1 2 3 4 5 6 7 8 9 1 0 1 1 Year Cash Flow for the Sulfur Removal Plant Project 1 Project 2 The pay period index would thus recommend project 1 in favor of proj-ect 2 (fewer years are required to recover the same initial capital incre-ment).

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  For the most part, studies have shown that compa- nies (1) use more sophisticated capital budgeting tech- niques today than in previous times and (2) do not rely on a single evaluation method to make decisions about purchasing capital projects. Clearly, firms still use pay- back period in their capital budgeting analyses. How- ever, even firms that previously relied on the traditional payback period seem to have switched to the discounted payback period. Thus, indications are that firms do use the methods we profess in finance courses. Period Traditional Payback Period NPV IRR 1970s 85% 65% 80% 1980s 78 75 88 1990s 60 80 79 2000s 53 85 77 11 Studies that were examined include Lawrence J. Gitman and John R. Forrester, Jr., “A Survey of Capital Budgeting Techniques Used by Major U.S. Firms,” Financial Management, Fall 1977, 66–71; David J. Oblak and Roy J. Helm, Jr., “Survey and Analysis of Capital Budgeting Methods Used by Multinationals,” Financial Management, Winter 1980, 37–41; Marjorie T. Stanley and Stanley B. Block, “A Survey of Multinational Capital Budgeting,” Financial Review, March 1984, 36–51; Glenn H. Petry and James Sprow, “The Theory of Finance in the 1990s,” The Quarterly Review of Economics and Finance, Winter 1993, 359–381; Erika Gilbert and Alan Reichert, “The Practice of Financial Management among Large United States Corporations,” Financial Practice and Education, Spring/Summer 1995, 16–23; Patricia Chadwell- Hatfield, Bernard Goitein, Philip Horvath, and Allen Webster, “Financial Criteria, Capital Budgeting Techniques, and Risk Analysis of Manufacturing Firms,” Journal of Applied Business Research, Winter 1996/1997, 95–104; John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, Vol. 60, No. 2–3, May/June 2001, 197–243; Patricia A. Ryan and Glenn P.

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  Infrastructure Investment

  An Engineering Perspective

  • David G. Carmichael(Author)
  • 2014(Publication Date)
  • CRC Press

    (Publisher)

  38 Infrastructure investment: An engineering perspective The interest rate that gives a PW of zero is approximately 15% per annum. The investment is acceptable at any rate below 15% per annum, but not above 15% per annum. Example A facility requires an initial investment of $100 000 and has an antici-pated annual return of $30 000 for 5 years. The IRR is calculated from setting the present worth of the returns for 5 years equal to $100 000. That is, 30000 1 r 1 r 1 r 100000 5 5 ( ) ( ) + -+ = Consider a range of values for r, r = 10% p.a. Left-hand side = 113 700 r = 20% p.a. Left-hand side = 89 700 r = 15% p.a. Left-hand side = 100 560 That is, the IRR is approximately 15% per annum. 3.4.1 Incremental rate of return With two alternative investments of different scales, an incremental anal-ysis, which looks at the differences between the two investments, might be used. The costs and benefits are subtracted for each year, and an IRR analysis is done on the incremental costs and benefits. 3.5 PAYBACK PERIOD The payback period (PBP) measure is used to determine the period or time (usually years) required to recover an investment’s outlay. The computa-tions might be carried out in one of two ways: • Nondiscounted payback period – The payback period is obtained by counting the number of years it takes for cumulative future cash flows to equal the investment outlay. Values used for B and C are nondis-counted values. • Discounted payback period – The payback period is obtained by counting the number of years it takes for cumulative discounted future cash flows to equal the investment outlay. Values used for B and C are discounted values. Appraisal 39 Nondiscounted payback period is suitable for quick analyses, for analysis over short payback periods, or where the interest rate doesn’t influence the calculated values significantly. Interpolation is used between time periods to establish fractions of periods.

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