Question

Trying to understand why these values were chosen for the payback period calculations

Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.

Solution

(cash flows in millions)		Cumulative Cash Flow
Year	Cash Flow
0	(50)	(50)
1	10	(40)
2	13	(27)
3	16	(11)
4	19	8
5	22	30

Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years

Answer 1

Payback period is the time within which cost of project is recovered back.

Negative figures show cost of project and positive figures show cash inflows.

In the 4th year cumulative cash flows become positive from negative.It means in 4th year, total cash inflows are more than cost.

So, in the 4th year, project is paying back.But, to find exact time of payback, remaining cost of 3rd year is divided from the total cash inflows of 4th year.

And, thus payback period is calculated.

In 3.58 Years project is earning amounts equal to the cost of project.