Payback period
Payback period
The length of time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years.
Method and format:
①Identify the initial investment.
②Identify the annual cashflow.
③Calculate the cumulative cashflow
④Calculate the payback period.
Decision Rule
a）Payback is often used as ‘first screening method’ .
b）Only select projects that pay back within the company’s target payback period （e.g. 3 years）
c）However, a project should not be evaluated on the basis of payback alone. If a project passes through payback test, it then should be evaluated with a more sophisticated investment technique.
Advantages:
·It is simple to calculate and simple to understand.
·It uses cash flows than accounting profits , which is less open to manipulation.
·May be important to companies with limited cash resources for budgeting purposes.
·Emphasis cash flow in the early years which tends to minimize the financial and business risk.
Disadvantages:
·It ignores the time value of money.
·It ignores cash flows after the payback period.
·There is no measure of return.
·Unable to distinguish between projects with same payback period.
·It may lead to excessive investment in short-term projects
Back：Level of working capital determined factors
Next：Summary of working capital management
The length of time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years.
Method and format:
①Identify the initial investment.
②Identify the annual cashflow.
③Calculate the cumulative cashflow
④Calculate the payback period.
Decision Rule
a）Payback is often used as ‘first screening method’ .
b）Only select projects that pay back within the company’s target payback period （e.g. 3 years）
c）However, a project should not be evaluated on the basis of payback alone. If a project passes through payback test, it then should be evaluated with a more sophisticated investment technique.
Advantages:
·It is simple to calculate and simple to understand.
·It uses cash flows than accounting profits , which is less open to manipulation.
·May be important to companies with limited cash resources for budgeting purposes.
·Emphasis cash flow in the early years which tends to minimize the financial and business risk.
Disadvantages:
·It ignores the time value of money.
·It ignores cash flows after the payback period.
·There is no measure of return.
·Unable to distinguish between projects with same payback period.
·It may lead to excessive investment in short-term projects
Back：Level of working capital determined factors
Next：Summary of working capital management
