Payback

11 Key excerpts on "Payback"

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  eBook - ePub

  Strategic Finance for Criminal Justice Organizations

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

    (Publisher)

  5

  It Is Time for PaybackThe Payback Time Method

  Time is money.*

  Benjamin Franklin

  5.1 Objectives

  The objectives of this chapter are to:

  • Understand the chronological perspective of capital budgeting • Understand the concept of the Payback time method • Understand the mathematical formula necessary to use the Payback time method • Understand the rendering of decisions using the Payback time method

  5.2 Introduction

  The methods of capital budgeting encompass perspectives of time, cash value, rate, and profitability potential. Examining projects from these perspectives involves the use of quantitative tools through which projects may be judged and selected as either acceptable or unacceptable for devoting the resources of the organization in the pursuit of such capital initiatives. The first capital budgeting method to be examined involves the time perspective of judging the acceptableness of potential capital investment projects. This method is known as the Payback method.

  Although the concepts of the time value of money were established among the previous chapters, the Payback method ignores the basic premise of the time value of money. Time calculations using the Payback method may involve the examination of long-term, strategic periods or they may involve much shorter periods. Regardless, the salient theme of the Payback method provides organizational leaders with a perspective of time when judging the acceptableness of potential capital investment projects.

  Having an understanding and knowledge of the perspective of time provides organizational leaders with information that may influence financial management decisions. Considerations of time are important for a variety of reasons. In some cases, both financial funding and other resources (e.g., personnel, vehicles) may be available to pursue capital investment projects, but an insufficient amount of time may exist in which the activities of the capital investment project are expected to be completed. In other cases, both time and financial funding may exist in sufficient quantities to facilitate the completion of a capital investment project, but other resources are insufficient to pursue a capital investment project. A third situation may arise in which all three considerations of financial funding, time, and additional resources may be insufficient to undertake and complete a capital initiative. Finally, another situation may be manifested in which all three considerations of financial funding, time, and additional resources are completely sufficient to undertake and complete a capital initiative.

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  Capital Budgeting

  Theory and Practice

  • Pamela P. Peterson, Frank J. Fabozzi(Authors)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  61 Chapter 4 Payback and Discounted Payback Period Techniques n this chapter we will discuss the Payback period technique and a variant of this technique, the discounted Payback period. Payback PERIOD The Payback period for a project is the length of time it takes to get your money back. It is the period from the initial cash outflow to the time when the project’s cash inflows add up to the initial cash out- flow. The Payback period is also referred to as the payoff period or the capital recovery period . If you invest $10,000 today and are promised $5,000 one year from today and $5,000 two years from today, the Payback period is two years — it takes two years to get your $10,000 investment back. Suppose you are considering investments A and B in Exhibit 1, each requiring an investment of $1,000,000 today (we’re consid- ering today to be the last day of the year 2000) and promising cash flows at the end of each of the following five years. How long does it take to get your $1,000,000 investment back? The Payback period for investment A is three years: By the end of 2002, the full $1 million is not paid back, but by 2003, the accumulated cash flow exceeds $1 million. Therefore, the pay- End of Year Expected Cash Flow Accumulated Cash Flow 2001 $400,000 $400,000 2002 400,000 800,000 2003 400,000 1,200,000 $1,000,000 investment is paid back 2004 400,000 1,600,000 2005 400,000 2,000,000 I 62 Payback and Discounted Payback Period Techniques back period for investment A is three years. Using a similar approach of comparing the investment outlay with the accumulated cash flow, the Payback period for investment B is four years — it is not until the end of 2004 that the $1,000,000 original investment (and more) is paid back. We have assumed that the cash flows are received at the end of the year. So we always arrive at a Payback period in terms of a whole number of years.

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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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  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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  eBook - ePub

  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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  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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  Managing Energy From the Top Down

  Connecting Industrial Energy Efficiency to Business Performance

  • Christopher Russell(Author)
  • 2021(Publication Date)
  • River Publishers

    (Publisher)

  How Does the Money Work? 133 • How does this investment compare with other ways to use money? Investors use Payback simply to decide whether they will accept or reject an investment proposal. The greater the inves-tor’s concern with investment loss, the shorter the Payback time demanded. For example, a 12-month Payback is preferred to a 24-month Payback, and a 6-month Payback is preferred to a 12-month Payback. Now take this to its logical conclusion: a zero-month pay-back would be most preferred—because there’s no wait to get the money back ! The investor is assured of avoiding loss only by making no investment at all. Payback only indicates if the investor should part with the money. It reduces investment analysis to a “yes/no” decision. As a consequence, this approach reduces energy management to a stop-and-go process. The company’s beleaguered energy manager has to reset his or her agenda back to zero with each project rejec-tion. Energy improvements need to be held to a different standard. Why? As seen on page 121, once a business commits to opera-tions, it commits to using energy. The question is not if it will buy energy, but how much energy will it buy, and at what price. Energy costs are not a yes/no choice, but a question of degree. Specifcally, how much do you want to pay for energy that ends up being wasted? Let’s be absolutely clear about this: use simple Payback when the alternative to investment is to keep the money . Ex-amples of investments like this would be to build or expand a facility, install equipment specifc to a new product line, or to buy back stock from shareholders. This is not the situation for the volume of energy at-risk. The alternative to making an energy-saving investment is to continue buying the energy that will be wasted—keeping the money is not an option! Proposed energy improvements should be evaluated by comparing the annualized cost to save a unit of energy to the delivered price of buying that same

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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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  The Essentials of Financial Modeling in Excel

  A Concise Guide to Concepts and Methods

  • Michael Rees(Author)
  • 2023(Publication Date)
  • Wiley

    (Publisher)

  In a general forecasting model, there is likely to be a time component. If the project is of an investment‐type, there will typically be an initial phase which is loss‐making and/or requires capital investment, followed by a phase in which positive returns are made. If the project is at all economically viable, then there will eventually be a time when it achieves the breakeven point. One could measure the time‐to‐breakeven in different ways including:

  Figure 11.5

  Time‐Based Forecast from Sales to EBITDA

  • (Breakeven time) The time that profit (or some other measure) reaches zero or a specific target.
  • (Payback period) The time at which cumulated profits (or the cumulated value of another measure) reach zero or another target.
  • (Discounted Payback period) The time at which cumulated profits (or the cumulated value of another measure) reach zero or another target, after discounting the items to reflect that value realized in the future are worth less than the same value today.

  Note that, in principle, the Payback period would be longer than the breakeven time (on the assumption that the profit is negative in the early periods). Similarly, the discounted Payback period would be longer than the Payback period, since future positive values would be discounted to become smaller than if they were not discounted. This chapter provides examples of the breakeven time and of the Payback period. The subject of discounting is treated in later chapters. (A reader with some existing knowledge may have noted that the discounted Payback period is equivalent to the first time at which the net present value of cumulated future discounted profit becomes positive.)

  Figure 11.5 shows a model with a forecast over time. The values in the initialization column (i.e. column F) are the same as those used in the previous Section (see Figure 11.1 ), while the forecast methods are the same as those used in earlier models (such as in Chapters 5 –7

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  Business Planning and Control

  Integrating Accounting, Strategy, and People

  • Bruce Bowhill(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Figure 4.2 Payback for projects A and B Activity 4.1 Calculate the Payback of project C. [ 89 ] C A P I T A L I N V E S T M E N T D E C I S I O N S The advantages and disadvantages of Payback Advantages Payback is popular because: 1. Cash flow is crucial to many companies and Payback measures the net cash generated by the project in the shorter term. 2. It can be used as a filter to reject projects, without the need to consider all the cash-flow implications. 3. It is a simple and easy-to-understand rule and can be used for small projects where a simple decision rule is adequate. Disadvantages 1. It does not consider the cash flows after the Payback cut-off point. After four years for project A, for example, there will be a major cash inflow, but this has been ignored. 2. Ignores the timing of cash flows and the cost of capital. Cash flows in later years are treated as being as important as the cash flows in earlier years. Accounting Rate of Return The Accounting Rate of Return (ARR) is the average annual profit divided by the initial investment. An investment would be accepted if its ARR was equal to or greater than a minimum ‘hurdle’ rate set by the organization. Profit is different from net cash flow Profit = cash flows from trading activities − non-cash items such as the cost of depreciation Average annual profit = Profit Number of years of the project The calculation of the accounting rate of return for project A is shown in Figure 4.3. [ 90 ] C H A P T E R 4 (i) Calculating average profit For project A the first step is to work out the average annual profit. The cash inflows from trading over the five years are 0 + £100,000 + £300,000 + £600,000 + £1,300,000 = £2,300,000. The asset cost £1,000,000 to purchase. The value at the end of the project was zero (nil residual value). Depreciation on the project is therefore £1,000,000.

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  Petroleum Economics and Engineering

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

    (Publisher)

  The payout period will accordingly be defined by point 4— that is, the time required to recover the depreciable capital only. Point 4 could be considered an alternative way (but different in value) to define payout period as the time needed for the cumulative expen-diture to balance the cumulative cash flow exactly. Book value of investment (with straight line depreciation) Time, Years Annual Net Profit After taxes (Constant) Total Capital Investment (Including land) LSW Recovery Zero cash line Net profit over total life of project End of project life (shutdown) Life of Project Earnings LSW Recovery C.C.P 3 M 2 M 1 M Construction Period Start of Construction Land Fixed Capital Investment (D epreciable) Working Capital Investment Zero Time Line LSW = Land, Salvage & Working Capital C.C.P = Cumulative Cash Position = Net Profit After Taxes + Depreciation-Total Capital Investment. Annual Depreciation Charge (Straight Line) Cash Position, $ –2 M –1 M –1 0 1 2 3 4 4 5 6 7 8 9 10 4 1 2 3 FIGURE 6.1 Illustration of payout period (P.P.). 123 Financial Measures and Profitability Analysis Usually oil companies seek to recover most of their capital investments in a short Payback period, mostly because of uncertainty about the future and the need to have funds available for later investments. This becomes especially important when the company is short of cash—emphasis on rapid recovery of cash invested in capital projects may be a necessity. The Payback period is used by oil companies in ascertaining the desirabil-ity of capital expenditures, because it is a means of rating capital proposals. 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.

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