The Payback Method

The payback period in capital budgeting refers to the period required for the return on an investment to "repay" the sum of the original investment.

The payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

To calculate a more exact payback period:

Payback Period = Amount to be initially invested / Estimated Annual Net Cash Inflow.

The payback period method does not take into account the time value of money. Some businesses modified this method by adding the time value of money to get the discounted payback period. They discount the cash inflows of the project by a chosen discount rate (cost of capital), and then follow usual steps of calculating the payback period.

Discount Rate The Central Bank of Russia set the discount rate from 1992 to 2009.

Additional complexity arises when the cash flow changes sign several times (i.e., it contains outflows in the midst or at the end of the project lifetime). The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then, the cumulative positive cash flows for each period are determined. The modified payback period is calculated as when the cumulative positive cash flow exceeds the total cash outflow.

Let's take a look at one example. Year 0: -1,000, year 1: 4,000, year 2: -5,000, year 3: 6,000, year 4: -6,000, year 5: 7,000. The sum of all cash outflows = $1,000 + $5,000 + $6,000 = $12,000.

The modified payback period is in year 5, since the cumulative positive cash flows ($17,000) exceeds the total cash outflows ($12,000) in year 5. To be more detailed, the payback period would be: 4 + 2/7 = 4.29 year.