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COMPUTER ORIENTED ACCOUNTING SYSTEM PAYBACK PERIOD METHOD
PAYBACK PERIOD METHOD
1. Introduction and Meaning
The Payback Period is one of the simplest and most commonly used traditional methods of capital budgeting. It measures the time required for a project to recover its initial investment from the net cash inflows generated by the project.
In simple words: How many years will it take to get back the money we invested?
If a project costs ₹ 1,00,000 and generates ₹ 25,000 per year, the payback period is 4 years. This means after 4 years, the investor has recovered the entire investment through the project’s cash flows.
Definition (Charles T. Horngren): “The payback period is the length of time required to recover the cost of an investment.”
Definition (L.J. Gitman): “Payback period is the time required for a firm to recover its original investment in a project from the net cash inflows.”
2. Features of Payback Period
- Time‑based measure – It expresses the result in years (or months).
- Focus on recovery, not profit – It does not measure total profitability; it only tells how fast the investment is recovered.
- Ignores time value of money – Cash flows in later years are treated the same as cash flows in early years.
- Simple to calculate – No need for discount rates or complex formulas.
- Emphasises liquidity – Shorter payback means quicker recovery, which reduces risk.
3. Formula and Calculation
Case A: When Annual Cash Inflows are Equal (Annuity)
Payback Period = Initial Investment / Annual Cash Inflow
Example:
- Investment = ₹ 2,00,000
- Annual cash inflow = ₹ 50,000
- Payback = 2,00,000 / 50,000 = 4 years
Case B: When Annual Cash Inflows are Unequal
In this case, we calculate cumulative cash flows year by year until the total equals or exceeds the initial investment.
Steps:
- List cash flows year by year.
- Calculate cumulative cash flow at the end of each year.
- Find the year in which cumulative cash flow equals or first exceeds the investment.
- If recovery happens within a year, calculate the fraction of that year.
Formula for fractional year:
Fraction = (Remaining amount to recover) / (Cash flow of that year)
Example (Unequal Cash Flows):
| Year | Cash Flow (₹) | Cumulative Cash Flow (₹) |
|---|---|---|
| 1 | 40,000 | 40,000 |
| 2 | 50,000 | 90,000 |
| 3 | 60,000 | 1,50,000 |
| 4 | 70,000 | 2,20,000 |
Investment = ₹ 1,50,000
By the end of year 3, cumulative = ₹ 1,50,000 (exactly recovered).
Payback = 3 years
Example (Recovery within a year):
Investment = ₹ 1,00,000
| Year | Cash Flow (₹) | Cumulative (₹) |
|---|---|---|
| 1 | 30,000 | 30,000 |
| 2 | 40,000 | 70,000 |
| 3 | 50,000 | 1,20,000 |
After year 2, cumulative = ₹ 70,000.
Remaining to recover = 1,00,000 – 70,000 = ₹ 30,000.
Year 3 cash flow = ₹ 50,000.
Fraction = 30,000 / 50,000 = 0.6 years = 7.2 months.
Payback = 2.6 years (or 2 years and 7.2 months)
4. Decision Rule
- Accept the project if the payback period is less than the management’s predetermined maximum target period.
- Reject the project if the payback period is greater than the target period.
- If two projects are compared, the one with the shorter payback period is preferred.
Example: Target payback = 4 years.
- Project A pays back in 3 years → Accept.
- Project B pays back in 5 years → Reject.
5. Solved Illustrations
Illustration 1 (Equal Cash Flows)
Problem: A machine costs ₹ 5,00,000. It is expected to generate annual cash inflows of ₹ 1,25,000. Calculate the payback period.
Solution: Payback = 5,00,000 / 1,25,000 = 4 years
Illustration 2 (Unequal Cash Flows – Exact Recovery)
Problem: Initial investment ₹ 2,50,000. Cash flows: Y1 ₹ 60,000; Y2 ₹ 80,000; Y3 ₹ 1,10,000; Y4 ₹ 70,000; Y5 ₹ 50,000. Find payback.
Solution:
| Year | Cash Flow (₹) | Cumulative (₹) |
|---|---|---|
| 1 | 60,000 | 60,000 |
| 2 | 80,000 | 1,40,000 |
| 3 | 1,10,000 | 2,50,000 |
Payback = 3 years
Illustration 3 (Unequal Cash Flows – Fractional Year)
Problem: Investment ₹ 3,00,000. Cash flows: Y1 ₹ 70,000; Y2 ₹ 90,000; Y3 ₹ 1,00,000; Y4 ₹ 80,000; Y5 ₹ 60,000. Compute payback.
Solution:
| Year | Cash Flow (₹) | Cumulative (₹) |
|---|---|---|
| 1 | 70,000 | 70,000 |
| 2 | 90,000 | 1,60,000 |
| 3 | 1,00,000 | 2,60,000 |
| 4 | 80,000 | 3,40,000 |
After year 3, cumulative = ₹ 2,60,000.
Remaining = 3,00,000 – 2,60,000 = ₹ 40,000.
Year 4 cash flow = ₹ 80,000.
Fraction = 40,000 / 80,000 = 0.5 year = 6 months.
Payback = 3.5 years (or 3 years 6 months)
Illustration 4 (With Scrap Value – Cash flow includes salvage)
Problem: Investment ₹ 4,00,000. Annual cash inflows (including salvage in final year) are: Y1 ₹ 80,000; Y2 ₹ 1,00,000; Y3 ₹ 1,20,000; Y4 ₹ 1,50,000 (includes salvage ₹ 30,000). Find payback.
Solution:
| Year | Cash Flow (₹) | Cumulative (₹) |
|---|---|---|
| 1 | 80,000 | 80,000 |
| 2 | 1,00,000 | 1,80,000 |
| 3 | 1,20,000 | 3,00,000 |
| 4 | 1,50,000 | 4,50,000 |
After year 3, cumulative = ₹ 3,00,000.
Remaining = 4,00,000 – 3,00,000 = ₹ 1,00,000.
Year 4 cash flow = ₹ 1,50,000.
Fraction = 1,00,000 / 1,50,000 = 0.667 year = 8 months.
Payback = 3.667 years (3 years 8 months)
6. Advantages of Payback Period
| Advantage | Explanation |
|---|---|
| Simple to calculate and understand | No complex formulas or discount rates are needed. Even non‑finance managers can use it. |
| Emphasises liquidity | It focuses on how quickly cash is recovered, which is important for firms with cash flow problems. |
| Reduces risk | Shorter payback periods mean less exposure to future uncertainties. |
| Useful for high‑risk industries | In industries where technology changes rapidly (e.g., IT), quick recovery is essential. |
| Easy to screen many projects | It can be used as a preliminary filter before applying detailed DCF methods. |
7. Disadvantages / Limitations of Payback Period
| Disadvantage | Explanation |
|---|---|
| Ignores time value of money | A rupee received today is treated the same as a rupee received after 5 years. |
| Ignores cash flows after payback | Profitable projects with longer payback may be rejected even if they generate huge returns later. |
| Does not measure profitability | It only tells recovery time, not whether the project is profitable overall. |
| No objective target period | The maximum acceptable payback is arbitrarily set by management. |
| May reject positive NPV projects | A project with high long‑term returns but moderate payback may be unfairly rejected. |
8. Payback Period vs Other Methods
| Basis | Payback Period | NPV | IRR |
|---|---|---|---|
| Time value of money | No | Yes | Yes |
| Considers all cash flows | No | Yes | Yes |
| Measures profitability | No | Yes (absolute) | Yes (percentage) |
| Complexity | Very low | Moderate | High |
| Best used for | Liquidity / Risk screening | Wealth maximisation | Rate of return comparison |
9. When is Payback Period Most Useful?
- Small businesses with limited capital and need for quick recovery.
- Industries with high technological obsolescence (computers, mobile phones, electronics).
- Projects in politically or economically unstable regions.
- As a preliminary screening tool before applying NPV or IRR.
- When management is risk‑averse and prefers early returns.
10. Practice Problems
Problem 1 (Equal cash flows)
A project requires an investment of ₹ 8,00,000. It generates annual cash inflows of ₹ 2,00,000. Calculate the payback period.
Problem 2 (Unequal cash flows – exact)
Investment ₹ 4,50,000. Cash flows: Y1 ₹ 1,00,000; Y2 ₹ 1,50,000; Y3 ₹ 2,00,000; Y4 ₹ 1,80,000; Y5 ₹ 1,20,000. Find payback.
Problem 3 (Fractional year)
Investment ₹ 2,80,000. Cash flows: Y1 ₹ 60,000; Y2 ₹ 80,000; Y3 ₹ 1,00,000; Y4 ₹ 90,000; Y5 ₹ 70,000. Compute payback in years and months.
Problem 4 (Comparison)
Two projects X and Y each require ₹ 5,00,000. Cash flows:
| Year | Project X (₹) | Project Y (₹) |
|---|---|---|
| 1 | 1,50,000 | 2,00,000 |
| 2 | 1,50,000 | 1,50,000 |
| 3 | 1,50,000 | 1,00,000 |
| 4 | 1,50,000 | 50,000 |
| 5 | 1,50,000 | 50,000 |
Which project has a shorter payback period? Which project is better based on total cash inflow? Discuss.
Problem 5 (With salvage)
Investment ₹ 6,00,000. Cash flows (including salvage in final year): Y1 ₹ 1,20,000; Y2 ₹ 1,80,000; Y3 ₹ 2,00,000; Y4 ₹ 2,50,000. Calculate payback.
11. Summary – Key Points
- Payback period = Time to recover initial investment.
- Formula: Investment / Annual cash inflow (if equal); cumulative method if unequal.
- Decision rule: Accept if payback < target period.
- Advantages: Simple, emphasises liquidity, reduces risk.
- Disadvantages: Ignores time value of money and post‑payback cash flows.
Practice Lab
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