Question

Based on Payback period, why do we choose a Project which take less years when compared to another

(Answer 1000 words)

Answer 1

The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.

Payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is.

1. Payback Period for Capital Budgeting,

The definition of the payback period for capital budgeting purposes is straightforward. The payback period represents the number of years it takes to pay back the initial investment of a capital project from the cash flows that the project produces.

The capital project could involve buying a new plant or building or buying a new or replacement piece of equipment. Most firms set a cut-off payback period, for example, three years depending on their business. In other words, in this example, if the payback comes in under three years, the firm would purchase the asset or invest in the project. If the payback took four years, it would not, because it exceeds the firm's target of a three-year payback period.

2. Calculating the Payback Period

Most small businesses prefer a simple calculation, or approximation, for a payback period:

Payback Period =	Initial Investment
Net Cash Flow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula:

Payback Period =	A +	B
C

Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A

The net annual cash inflow is what the investment generates in cash each year. However, if this investment was a replacement investment such as a new machine replacing an obsolete machine, then the annual cash inflow would become the incremental net annual cash flow from the investment.​

The project's payback occurs the year (plus a number of months) before the cash flow turns positive.

3. Let us understand the payback period method with a few more illustrations.

In the First illustrations,

Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. The payback period for this investment is four years—dividing $1 million by $250,000. Consider another project that costs $200,000 with no associated cash savings will make the company an incremental $100,000 each year for the next 20 years at $2 million. Clearly, the second project can make the company twice as much money, but how long will it take to pay the investment back?

The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back and the company's earnings potential is greater. Based solely on the payback period method, the second project is a better investment.

In the Second illustrations,

Apple Limited has two project options. The initial investment in both the projects is Rs. 10,00,000.

Project A has even inflow of Rs. 1,00,000 every year.

Project B has uneven cash flows as follows:

Year 1 – Rs. 2,00,000

Year 2 – Rs. 3,00,000

Year 3 – Rs. 4,00,000

Year 4 – Rs. 1,00,000

Now let us apply the payback period method to both the projects.

Project A

If we use the formula, Initial investment / Net annual cash inflows then:

10,00,000/ 1,00,000 = 10 years

Project B

Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000)

Total outflows = 10,00,000

Project B takes four years to get back the initial investment.

Now to find out the payback period:

Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two.

Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.

So that is: 5/7 = 0.71

Step 3: Step 1 + Step 2 = The payback period is 2.71 years.

Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected.

The example stated above is a very simple presentation. In an actual scenario, an investment might not generate returns for the first few years. Gradually over time, it might generate returns. That too will play a major role in determining the payback period.

In the Third illustrations,

Let's say you have two machines in your warehouse. Machine A costs $20,000 and your firm expects payback at the rate of $5,000 per year. Machine B costs $12,000 and the firm expects payback at the same rate as Machine A. Calculate the two scenarios as follows:

Machine A = $20,000/$5,000 = 4 years

Machine B = $12,000/$5,000 = 2.4 years

With all other things equal, the firm would choose Machine B.

4. Decision Rule i.e "why do we choose a project which take less years when compared to another"

The longer the payback period of a project, the higher the risk. Between mutually exclusive projects having similar return, the decision should be to invest in the project having the shortest payback period. When deciding whether to invest in a project or when comparing projects having different returns, a decision based on the payback period is relatively complex. The decision whether to accept or reject a project based on its payback period depends upon the risk appetite of the management.