PAYBACK METHOD Payback period method refers to measures how quickly the firm can recover its initial outlay. From definition given, it shows the time taken, normally in number of years, which particular project takes tp recover the original investment.
The project is accepted if it gives the shortest payback period to the f irm. This method also reflects the true timing of the benefits and costs of the project proposed. Thus, it does not take into consideration the time value of money, which is it does not calculate the Present Value of cash flow. The formula of Payback Period is Initial outlay Payback period
=
Annual Cash Flow
ILLUSTRATION 1 A firm is evaluating a project with an initial outlay of RM 200,000. The project is expected to generate RM 60,000 every year for the next five years. Determine the payback period of the project. SOLUTION: Payback period
=
Initial outlay Annual cash flow
=
RM200,000 RM60,000
=
3.33 year (3 years and 4 months).
ILLUSTRATION 2: Assume the firm in example 1 above is considering another project. The relevant cash flows are as given:
RM Initial outlay
500,000
After-tax differential cash flows: Year 1 to 3
150,000
Year 4 to 5
200,000
Calculate the payback period of the project
SOLUTION: Since the differential cash flows differ, the calculation of the payback period will not be as straightforward as in example 1. Differential cash flows: Years 1 to 3 = RM150,000 x 3 years = RM450,000. We still need RM50,000 (RM500,000 ± RM450,000) to recover our initial outlay. RM50,000
=
0.25
RM200,000
Therefore, the payback period = 3 years + 0.25 year = 3.25 years ALTERNATIVE SOLUTION: Initial outlay = RM500,000
Year
Annual After-tax Cash Flows (RM)
Accumulated ash Flows (RM)
1
150,000
150,000
2
150,000
300,000
3
150,000
450,000
4
200,000
Payback period = 3 + (RM500,000 ± RM450,000) --------------------------------------RM200,000 = 3.25 years.
Decision Criteria: 1. A project will be accepted if its payback period is less than or equal to the firm¶s maximum desired payback period.
ADVANTANGES OF PAYBACK PERIOD There is simplicity in its calculation. It is also easily understood by most people. This method stresses on earlier returns. This is why it is often used as an initial screening process by firms to eliminate the investment proposals whose returns do not materialize until later years. It reflects the true timing of the benefits and costs involved in the capital budgeting project by using cash flows and not accounting profits.
DISADVANTAGES It ignores the time value of money, making it less accurate. It ignores cash flows occurring after the payback period.
It is biased against long-term projects, as these projects will normally return the initial outlay much later.
DISCOUNTE D
PAYBACK PERIOD Discounted payback period is similar with the payback period, except discounted payback period applies the time value of money concept. Therefore, discounted payback period measures the number of years required to earn back the initial investment from the discounted cash flows. FORMULA
EXAMPLE Assume the ABC Bhd is considering a new project. The relevant cash flows are as given:
RM Initial outlay
500,000
After-tax differential cash flows: Year 1 to 3
150,000
Year 4 to 5
200,000
Assuming a discount rate of 12% is given. Calculate the discounted payback period of this project. SOLUTION
Year 1 2 3 4 5
Annual After-tax CF (RM) 150,000 150,000 150,000 200,000 200,000
Initial outlay = RM500,000 PVIF@12% Discounted CF 0.8929 0.7972 0.7118 0.6355 0.5674
133,935 119,580 106,770 127,100 113,480
Accumulated CF 133,935 253,515 360,285 360,285
Payback period =
=
4 + (RM500,000 ± RM487,385) -----------------------------------------RM 113,480 4.11 years
ADVANTAGES OF DISCOUNTED PAYBACK PERIOD 1) Discounted payback period takes account of time value of money. 2) Discounted future cash flows. 3) Discounted payback period useful for firms with liquidity problems. DISADVANTAGES
1) 2) 3) 4)
Discounted payback ignores cash flows after threshold It also ignores some risks differences between projects. Discounted payback can be hard to estimate discount rate. It is still very much arbitrary in terms of determining the firm¶s maximum desired discounted payback period.
