Payback and Discounted Payback Period
1.4. Example: Uneven Cash Flows
A project requires a cash outlay of Rs 20,000 and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 over the next 4 years.
- After 3 years, a total of Rs 19,000 is recovered.
- In year 4, the cash inflow is Rs 3,000. Rs 1,000 is still to be recovered.
- Time to recover Rs 1,000: (1,000 / 3,000) * 12 months = 4 months.
- Payback period: 3 years and 4 months.
1.5. Acceptance Rule
- Firms compare the project's payback with a pre-determined standard payback period.
- Projects are accepted if their payback period is less than the standard payback period.
- As a ranking method, projects with the shortest payback periods are ranked higher.
- When choosing between mutually exclusive projects, the project with the shorter payback period is chosen.
1.6. Evaluation of Payback Method
1.6.1. Advantages:
- Simplicity: It's easy to understand and calculate, making it popular in practice.
- Cost-Effective: It's less expensive than more complex techniques, saving time and resources.
- Short-Term Effects: It can improve short-run earnings per share by setting a shorter standard payback period.
- Risk Shield: It can be used as a risk management tool by ensuring quick recovery of investment.
- Liquidity Insight: It provides an insight into the liquidity of the project, with emphasis on early recovery of investment.
1.6.2. Limitations:
- Ignores Cash Flows After Payback: It fails to consider cash inflows earned after the payback period.
- Ignores Total Cash Flows: It's not a reliable measure of profitability as it ignores the overall cash flows generated by a project.
- Ignores Cash Flow Patterns: It doesn't account for the timing of cash inflows. It treats all benefits received the same irrespective of when they are received.
- Administrative Difficulties: Setting a maximum acceptable payback period is subjective and lacks a rational basis.
- Inconsistent with Shareholder Value: It is not aligned with the objective of maximizing shareholder value.
1.7. Payback Reciprocal and Rate of Return
- Approximation of Rate of Return: Under certain conditions, the reciprocal of the payback period can be a rough approximation of the internal rate of return (IRR).
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Conditions for Approximation:
- The life of the project is large, or at least twice the payback period.
- The project generates equal annual cash inflows.
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Limitations:
- Every project does not meet the above conditions.
- The payback reciprocal will always exceed the IRR when the project’s life is not at least twice the payback.
- It cannot be used when the cash inflows are uneven.
2. Discounted Payback Period
2.1. Definition
The discounted payback period is a variation of the payback method that addresses one of its major flaws: it considers the time value of money by discounting cash flows. This method determines the number of periods required to recover the investment outlay, using the present values of cash inflows.
2.2. Calculation
- Discount all future cash inflows to their present value using a chosen discount rate.
- Determine the payback period using these discounted cash flows.
2.3. Example
Projects P and Q require an outlay of Rs 4,000 each. The opportunity cost of capital is 10%.
| Project | C0 | C1 | C2 | C3 | C4 | Simple PB | PV of Cash Flows | Discounted PB | NPV at 10% |
|---|---|---|---|---|---|---|---|---|---|
| P | -4000 | 3000 | 1000 | 1000 | 1000 | 2 years | -4000 2727 826 751 683 | 2.6 years | 987 |
| Q | -4000 | 0 | 4000 | 1000 | 2000 | 2 years | -4000 0 3304 751 1366 | 2.9 years | 1421 |
- The simple payback period indicates equal desirability of the projects.
- The discounted payback period makes it clearer that project P will recover its outlay quicker than Q when considering the time value of money. Project Q is clearly better as it has a higher NPV.
2.4. Limitations
- Fails to Consider Cash Flows After Payback: Like the traditional payback period, the discounted payback method ignores cash flows after the payback period is reached.
- Not a Measure of Profitability: It is better than the simple payback method, but it is not a good way to measure the overall profitability of an investment.
3. Summary
| Technique | Definition | Advantages | Limitations |
|---|---|---|---|
| Payback Period (PB) | Time to recover initial investment. | Simplicity, cost-effective, provides liquidity insight, focus on risk. | Ignores cash flows after payback, ignores time value of money, is not a measure of profitability, inconsistent with shareholder value |
| Discounted Payback Period | Time to recover initial investment, using present values of future cash inflows. | Accounts for time value of money compared to simple payback. | Ignores cash flows after payback, is not a measure of profitability. |
4. Conclusion
The payback period and discounted payback period are easy-to-understand techniques, primarily focused on the speed of recovering an investment outlay. While they are used in practice, they both suffer from significant limitations, especially as they are not valid measures of profitability. More sophisticated techniques like Net Present Value (NPV) or Internal Rate of Return (IRR) should be preferred for making robust investment decisions, as they are more aligned with the objective of maximizing shareholder wealth. The payback period, however, can be used as a first screening to filter out projects, but should not be used as a definitive measure of investment viability.