3. Payback period and discounted payback period

The Payback Period is the length of time it takes for the project’s cash flows to equal its investment. Decision Rule: Undertake the project if the payback is less than a preset amount of time.

To calculate Payback Period: determine when the Project’s cumulative cash flow becomes positive.

The payback answers to the question how long will it take for the project to generate enough cash to pay for the initial investment?

For example: An investment has the following cash flows

-100 + 20+ 30+ 40+ 20+30+30+10 The payback would be 3.5 years.

If we have only one project is this 3.5 years good? Companies uses this payback Period comparing them with pre-set thresholds (cutoffs). If threshold for similar projects is Payback in 5 years, what would be decision? Accept the project.

Drawbacks of payback period

    · Benchmarks are subjective.

·  It does not consider time value of money.

    ·  It does not consider required rate of return (hurdle rate).

    ·  It does not consider all of the project’s cash flows over its life.

The discounted Payback period

The Discounted Payback Period is the length of time it takes for the Project’s discounted cash flows to equal its investment. Decision Rule: Undertake the Project if the discounted payback is less than a preset amount of time.

The discounted payback period fixes up some problems of the payback period like consider time value of money and the required rate of return. However both require an arbitrary cutoff value and ignore cash flows after the Payback period.