Offer ends on
0
DAYS
0
HOURS
0
MINS
0
SECS
2020-04-28 10:44:58Cash FlowEnglishPayback Period is nothing but the number of years it takes to recover the initial cash outlay invested in a particular project.https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2020/04/Payback-Period-Formula.pnghttps://quickbooks.intuit.com/in/resources/cash-flow/payback-period-formula/Payback Period Formula: Meaning, Example and Formula

Payback Period Formula: Meaning, Example and Formula

3 min read

Try QuickBooks Invoicing & Accounting Software – 30 Days Free Trial.


Payback Period is nothing but the number of years it takes to recover the initial cash outlay invested in a particular project.Accordingly,

Payback Period formula= Full Years Until Recovery + (Unrecovered Cost at the beginning of the Last Year/Cash Flow During the Last Year)

Capital Budgeting is one of the important responsibilities of a finance manager of a company.

The capital budgeting process involves identifying and evaluating capital projects, that is, the projects in which a business entity would receive cash flows over a period of more than one year.

Since the capital projects involve investment decisions in long term assets, sound capital budgeting decisions become all the more important.

This is because such decisions cannot be reversed at a low cost given the large amount that makes up the long term assets of the business entity.

Various capital budgeting techniques are used to help management evaluate various investment projects. Payback Period is one of the techniques used to analyze whether a particular investment project should be accepted or rejected.

What is Payback Period?

Payback Period is the number of years it takes to recover the initial investment or the original investment made in a project. It is based on the incremental cash flows from a particular investment project.

Thus, various investment proposals are evaluated based on the number of years it takes for a business entity to recover the initial cost of the investment proposal. Typically, the investment project with a shorter pay back period is preferred over alternate investment projects.

Characteristics of Payback Period Method

  • Payback Period method is one of the traditional methods of capital budgeting. It helps a business entity decide upon the desirability of an investment proposal based on the useful life and the expected returns of a project.
  • This method does not take into account time value of money which is an important factor in determining the desirability of an investment project used in other capital budgeting methods.
  • Payback Period is one of the oldest and simplest methods to evaluate investment proposals and is widely used in the small scale sector.
  • Payback period is calculated based on the information available from the books of accounts of a business entity.

Payback Period Formula

As mentioned above, Payback Period is nothing but the number of years it takes to recover the initial cash outlay invested in a particular project.

Accordingly,

Payback Period = Full Years Until Recovery + (Unrecovered Cost at the Beginning of the Last Year/Cash Flow During the Last Year)

Payback Period Example

Let’s understand the Payback Period Formula and its application with the help of the following example.

Say, Kapoor Enterprises is considering investments A and B each requiring an investment of Rs 20 Lakhs today and cash flows at the end of each of the following 5 years. Let’s evaluate how much time does it take to get this initial investment of Rs 20 Lakhs back in each of the projects.

The following table shows the expected cash flows from investment proposals A and B.

Proposal A
Year EndExpected Cash InflowsCumulated Cash Inflows
0(20,00,000)(20,00,000)
12,00,000(18,00,000)
22,00,000(16,00,000)
32,00,000(14,00,000)
42,00,000(12,00,000)
52,00,000(10,00,000)
62,00,000(8,00,000)
72,00,000(6,00,000)
82,00,000(4,00,000)
92,00,000(2,00,000)
102,00,0000
112,00,0002,00,000

Thus for Proposal A,

Payback Period = Full Years Until Recovery + (Unrecovered Cost at the beginning of the Last Year/Cash Flow During the Last Year)

= 9 + (2,00,000/2,00,000)

= 9 + 1

= 10 Years

Proposal B
Year-EndExpected Cash InflowsCumulated Cash Inflows
0(20,00,000)(20,00,000)
12,00,000(18,00,000)
23,00,000(15,00,000)
34,00,000(11,00,000)
42,00,000(9,00,000)
54,00,000(5,00,000)
65,00,0000
74,00,0004,00,000

Thus for Proposal B,

Payback Period = Full Years Until Recovery + (Unrecovered Cost at the Beginning of the Last Year/Cash Flow During the Last Year)

= 5 + (5,00,000/5,00,000)

= 5 + 1

= 6 Years

Since Project B has a shorter Payback Period as compared to Project A, Project B would be better. However, the business entity should not take investment decisions simply on the basis of the Payback Period of the investment proposals given the inherent drawbacks of the Payback Period Method.

Demerits of Payback Period Method

As mentioned above, Payback Period Method neither takes time value of money nor cash flows beyond the payback period into consideration. This means that the terminal or the salvage value would not be considered. Hence, the payback period is not a useful method to measure profitability.

For instance, in the example above, Rs 20 Lakhs invested might seem profitable today. However, such an investment made over a period of say 10 years may not hold the same value.

Likewise, the proposals considered above might generate greater cash inflows during the later years of the investment project which is ignored if payback period method is used to evaluate investment proposals.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Related Articles

ICAI Guidelines on the Impact of Coronavirus on Auditing of Financial Statements

The outbreak of COVID-19 has compelled the government to undertake measures such…

Read more

Impact of COVID-19 on Financial Reporting

To guide auditors as well as chartered accountants, ICAI has developed an…

Read more

How to Conduct Remote Auditing Effortlessly Amidst Crisis?

In this article, you will learn: Use of Right Technologies Digitization of…

Read more