Payback Period (Cambridge International A-Level Accounting)

Spec point — how to apply the following capital investment appraisal techniques: – payback the advantages and disadvantages of these capital investment appraisal techniques

Payback period

What is the payback period of an investment?

• The payback period is the length of time it takes for an investment to recover its initial cost from net cash inflows
• Owners usually prefer investments which have a shorter payback period
• If payback exceeds a company's target payback period, the project should be rejected

How do I calculate the payback period?

• STEP 1 Calculate the net cash flow for each year

• STEP 2 Calculate the cumulative net cash flow for each year

  • The cumulative net cash flow for Year 0 is the same as its net cash flow
  • The cumulative net cash flow for Year 1 is the net cash flows for Year 0 and Year 1 added together
  • The cumulative net cash flow for Year 2 is the net cash flows for Year 0, Year 1 and Year 2 added together
  • The cumulative net cash flow for any year is equal to that year's net cash flow added together with all the previous net cash flows

• STEP 3 Identify the first year when the cumulative net cash flow is positive

  • Call this the recovery year

• STEP 4 Calculate the payback period

  • The number of years is the year before the recovery

    • If the recovery year is Year 4, this means the payback period is 3 years plus some additional days

  • The number of days is found using the formula

    • $\frac{\mathrm{Remaining} \mathrm{cost} \mathrm{to} \mathrm{recover}}{\mathrm{Cash} \mathrm{flow} \mathrm{in} \mathrm{recovery} \mathrm{year}}\times365$

Exam Hint The number of days will usually be a decimal. Make sure you round up to the next whole number. For example, 45.1 would round to 46 days.

What are the advantages and disadvantages of the payback period method?

Advantages

• It is simple and quick to calculate

• It is easy for non-accountants to understand

• It is useful for businesses with liquidity concerns

• It reduces the risk

  • The shorter the payback, the less uncertainty

Disadvantages

• It ignores cash flows after the payback period
• It ignores the time value of money
• It does not measure overall profitability

Worked Example The directors of D plc are considering the purchase of a new machine, costing $220 000, to manufacture a newly developed product, Product Omega. The directors intend to manufacture the product for only four years, after which the machine will have zero residual value.

The directors have estimated the following net cash flows arising from the project:

Year	Net cash flow ($)
1	45 000
2	60 000
3	105 000
4	30 000

Calculate the payback period for the new machine in years and days.

Answer:

Include the initial cost as Year 0

Work out the cumulative net cash flow for each year by keeping a running total of the net cash flows

Year	Net cash flow ($)**	Cumulative net cash flow ($)
0	(220 000)	(220 000)
1	45 000	(175 000)
2	60 000	(115 000)
3	105 000	(10 000)
4	30 000	20 000

The recovery year is Year 4

• This means the payback period is over 3 years

Find the number of days it takes to recover the costs during Year 4

• There is $10 000 left to recover at the start of the year
• The net cash flow for the year is $30 000

$\frac{10000}{30000}\times365=121.6...$

Round up to the next day

Final answer: Payback period is 3 years and 122 days