The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income. Pay back period is an investment appraisal technique that tells the amount of time taken by the investment to recover the initial investment or principal. It is one of the simplest capital budgeting techniques. It calculates the number of years a project takes in recovering the initial investment based on the future expected cash inflows.
Calculation of Pay Back Period (PBP)
The calculation of pay back period is very simple and its interpretation too.
There are two ways of calculating PBP:
(1) Even Cash Flow
Even cash flows mean that the investment is expected to bring in income that is constant each year. Even cash flow is also known as an equal amount of cash flow during the life period of the project. 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.
The following formula is used to calculate PBP if cash flow is equal: PBP = Investment/Constant annual cash flow after tax (CFAT). The cost of the machine is $28,120, and it is expected to bring the company a net cash flow of $7,600 per year for the next fifteen years of the machine’s useful life.
Example: Company C is planning to undertake a project requiring an initial investment of $105 million. The project is expected to generate $25 million per year in net cash flows for 7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years
(2) Uneven Cash Flow
If the amount of cash flow is different, it is known as uneven cash flow. Uneven cash flows occur when the annual cash flows are not the same amount each year. In such a situation, PBP is calculated by the process of cumulating cash flow still the time when cumulative cash flow becomes equal to the original investment outlay. Under these circumstances, the formula that we used before will not work but being the wise business manager that you are, you still know how to figure out the PBP for this project. The following formula is used to calculate PBP when cash flow is not equal: PBP = Minimum year + Amount to be recovered investment/CFAT of next year.
