The pay-back period refers to the period within which the total investment made in a project pays itself back. Pay-back period method assumes that every capital expenditure pays itself back within a particular period out of the additional earnings generated from the capital assets. It shows the time period within which the original cost of a project can be recovered from the additional earnings generated by the project itself. Under this method, several projects are ranked as per the length of their respective pay-back period and the project having a shorter payback period is preferred to the one having a longer pay-back period. However, in case of a single project, it is accepted if its pay-back period is within the period as specified by the management. If not, the project is not accepted.
Determination of Pay-back period in case of even annual cashflow
In order to calculate the pay-back period, first we have to identify the initial outlay (outflow) of the project. Then, we have to ascertain the annual cash inflows which is the net annual earnings before depreciation but after tax. Now, by dividing the initial outlay by the annual cash inflow we will get the pay-back period for the project.
Example
A project requires a cash outlay of Rs 90,000/- and yields an annual cash inflow of Rs 18,000/- for a period of 10 years. Calculate the pay back period for the project.
Solution:
Pay-back period= Initial outlay of the Project/Annual Cash Flow
= 90,000/18,000
= 5 years
Determination of Pay-back period in case of uneven annual cashflow
In case of a project, where the annual cash inflows are uneven, the pay-back period can be calculated by adding the annual cash inflows until the total is equal to the initial cash outlay for the project.
Example
A project requires a cash outlay of Rs 97,500/- and yields annual cash inflows of Rs 30,000/-, Rs 50,000/- and Rs 70,000/- in the first, second and third year respectively. In this case, the pay-back period would be determined as below-
Total cash outflow= Rs 97,500/-
Total cash inflow for first 2 years = Rs 30,000 + Rs 50,000 = Rs 80,000
Therefore, upto 2nd year Rs 80,000/- has been recovered and the balance of Rs 17,500/- is yet to be recovered. However, cash inflow for the third year is Rs 70,000/-. As such, pay back period is somewhere between the 2nd and 3rd year.
The required time to recover Rs 17,500/- would be: (17,500/70,000)12= 3 months Therefore, payback period for the project is 2 years and 3 months.
Conclusion
Pay-back period method is simple, easy to calculate and less costly. Under this method, a project having a shorter pay-back period is preferred to the one which have a longer pay-back period. However, this method does not recognise the cash inflows occurred after the pay-back period. As such, the true profitability of a project can not be correctly determined.