Capital Budgeting: Long Range Planning

The payback period is the time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay. In effect, the payback period answers the question: How long will it take the capital project to recover, or pay back, the initial investment? If the net cash inflows each year are a constant amount, the formula for the payback period is:

$\text{Payback period} = \dfrac{\text{Initial cash outlay}}{\text{Annual net cash inflow (benefit)}}$

For the two assets discussed in the previous section, you can compute the payback period as follows. The purchase of the USD 120,000 equipment creates an annual net cash inflow after taxes of USD 18,200, so the

payback period is 6.6 years, computed as follows:

$\text{Payback period} = \dfrac{\text{USD} 120,000}{\text{USD 18,200}} = 6.6 \text{years}$

The payback period for the replacement machine with a USD 28,000 cash outflow in the first year and an annual net cash inflow of USD 2,600, is 10.8 years, computed as follows:

$\text{Payback period = USD 28,000/USD 2,600 = 10.8 years}$

Remember that the payback period indicates how long it will take the machine to pay for itself. The replacement machine being considered has a payback period of 10.8 years but a useful life of only 8 years. Therefore, because the investment cannot pay for itself within its useful life, the company should not purchase a new machine to replace the two old machines.

In each of the previous examples, the projected net cash inflow per year was uniform. When the annual returns are uneven, companies use a cumulative calculation to determine the payback period, as shown in the following  situation.

Neil Company is considering a capital investment project that costs USD 40,000 and is expected to last 10 years.

The projected annual net cash inflows are:

The payback period in this example is six years - the time it takes to recover the USD 40,000 original investment.

When using payback period analysis to evaluate investment proposals, management may choose one of these rules to decide on project selection:

• Select the investments with the shortest payback periods.
• Select only those investments that have a payback period of less than a specified number of years.

Both decision rules focus on the rapid return of invested capital. If capital can be recovered rapidly, a firm can invest it in other projects, thereby generating more cash inflows or profits.

Some managers use payback period analysis in capital budgeting decisions due to its simplicity. However, this type of analysis has two important limitations:

• Payback period analysis ignores the time period beyond the payback period. For example, assume Allen Company is considering two alternative investments; each requires an initial outlay of USD 30,000. Proposal Y returns USD 6,000 per year for five years, while proposal Z returns USD 5,000 per year for eight years. The payback period for Y is five years (USD 30,000/USD 6,000) and for Z is six years (USD 30,000/USD 5,000). But, if the goal is to maximize income, proposal Z should be selected rather than proposal Y, even though Z has a longer payback period. This is because Z returns a total of USD 40,000, while Y simply recovers the initial USD 30,000 outlay.
• Payback analysis also ignores the time value of money. For example, assume the following net cash inflows are expected in the first three years from two capital projects:

Assume that both projects have the same net cash inflow each year beyond the third year. If the cost of each project is USD 36,000, each has a payback period of three years. But common sense indicates that the projects are not equal because money has time value and can be reinvested to increase income. Because larger amounts of cash are received earlier under Project A, it is the preferable project.