Method To Calculate Payback Finance Essay

July 13, 2017 History

TheA payback method of analysis of capital budgeting method that calculates the sum of clip it will take to reimburse theA investmentA in aA capital plus, with no respect for the clip value of money. For illustration, an investing of $ 20,000 that will bring forth annualA hard currency flowsA of $ 4,000 has a payback period of five old ages.

Payback Period

The length of clip required to retrieve the cost of an investing. The payback period of a given investing or undertaking is an of import determiner of whether to set about the place or undertaking, as longer payback periods are typically non desirable for investing places.

Method To Calculate Payback Period

Payback Period = Cost of Project / Annual Cash Inflows

When hard currency influxs are uneven, we need to cipher the cumulative net hard currency flow for each period and so utilize the undermentioned expression for payback period:

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Payback Period = A +A

Bacillus

C

In the above expression,

A = Last period with a negative cumulative hard currency flow,

B = Absolute value of cumulative hard currency flow at the terminal of the period A,

C = Actual hard currency flow during the period after A.

Payback periodA refers to the period of clip required for the return on an investing to “ refund ” the amount of the original investing. For illustration, a $ 2000 investing which returned $ 1000 per twelvemonth would hold a two twelvemonth payback period. TheA clip value of moneyA is non taken into history. Payback period measures how long something takes to “ pay for itself. ” All else being equal, shorter payback periods are preferred to longer payback periods. Payback period is widely used because of its easiness of usage despite the recognized restrictions described below.

Decision Rule

A determination regulation is a process to make up one’s mind whether to accept or reject theA projectA .

Example

Ram Singh & A ; Co. is be aftering to take a undertaking necessitating initial investing of $ 200 million. The undertaking is expected to bring forth gross of $ 50 million per twelvemonth for 10 old ages. Calculate the payback period.

Solution

Payback Period = Initial Investment / Annual Cash Flow = $ 100M / $ 25M = 4 old ages

Important Thingss to be Considered for utilizing payback period

Payback period is an appealing metric because it has an easy understood significance. Nevertheless, here are some points to maintain in head when usingA payback period:

Payback can non be calculated if the positive hard currency influxs do non outweigh the hard currency escapes. That is why payback is of small usage when used with a pure “ costs merely ” concern instance orA cost of ownershipA analysis.

There can be more than one payback period for a given hard currency flow watercourse. Payback period illustrations such as the one above typically show cumulative hard currency flow increasing continuously. In existent universe hard currency flow consequences, nevertheless, cumulative hard currency flow can diminish every bit good as addition from period to period.A When cumulative hard currency flow is positive in one period, but negative once more in the following, thereA is more than one Payback Period point.

Payback period by itself says nil about hard currency flows coming after the payback clip. One investing may hold a shorter payback period than another, but the latter may travel on to greater cumulative hard currency flow over clip.

Payback computation normally does non acknowledge theA clip value of moneyA ( in dismissing sense ) nor does it reflect money coming in after payback ( contrast with discountedA andA internal rate of return, above ) .

Advantages and Disadvantages Of Payback Period

Advantages

Payback period is simple to cipher.

It can mensurate of hazard in a undertaking. Cash flows that occur subsequently in a undertaking ‘s life are considered unsure, payback period provides an information or thought of how certain the undertaking hard currency influxs are.

For companies confronting job of liquidness, it provides a good ranking of undertakings that would return money early.

Payback period trades with hazard related to the undertaking.

The short-run attack of payback period method is an added advantage.

Disadvantages

Payback period do non take in history theA clip value of moneyA which is a serious drawback since it could take to incorrect determinations. A fluctuation of payback method that attempts to take this drawback is calledA discounted payback periodA method.

It does non take into history, the hard currency flows that occur after the payback period is reached.

The payback period ignores the salvage value and the project`s entire economic life.

The payback period is we can state a method of capital recovery alternatively a step of profitableness of a undertaking.

The payback period is made to cover the conventional undertakings that involve big sum of investing followed by positive operating hard currency influxs. It breaks down when the investing is spread over clip or where there is no initial investing.

Calculation of payback period of machines:

Machine1

Machine2

Machine3

Initial investing ( a )

Rs.3,00,000

Rs.3,00,000

Rs.3,00,000

Gross saless ( B )

5,00,000

4,00,000

4,50,000

Costss:

Direct stuff

40,000

50,000

48,000

Direct labor

50,000

30,000

36,000

Factory operating expense

60,000

50,000

58,000

Depreciation

1,30,000

91,667

90,000

Administration cost

20,000

10,000

15,000

Selling and Distribution costs

10,000

10,000

10,000

Entire cost A©

3,10,000

2,41,667

2,57,000

Net income before revenue enhancement ( b-c )

1,90,000

1,58,333

1,93,000

Less: revenue enhancement @ 40 %

76,000

63,333

77,200

Net income after revenue enhancement

1,14,000

95,000

1,15,800

Attention deficit disorder: depreciation

1,30,000

91,667

90,000

Net hard currency flow ( vitamin D )

2,44,000

1,86,667

2,05,800

Payback period ( old ages ) ( a/d )

1.23

1.61

1.46

Machine 1 has lowest payback period, so it may be preferred over the other two machines.

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