CIMA BA2 Syllabus D. DECISION MAKING - Payback - Notes ^{2 / 3}

Payback Period (non discounted)

The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. 

This period is sometimes referred to as "the time that it takes for an investment to pay for itself." 

The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. 

If we are using this method as a means of choosing which investment to do, then we will choose the one with the shortest payback period

Hence, this method focuses on liquidity.

The payback period is expressed in years. 

When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.

Formula / Equation - If annual inflows are the same each year

The formula or equation for the calculation of payback period is as follows:

Payback period = Investment required / Net annual cash inflow

Illustration - Constant Cash Flow

Initial cost $3,600,000
Cash in annually $700,000

What is the payback period?

Solution

3,600,000 / 700,000 = 5.1429 years

Take the decimal (0.1429) and multiply it by 12 to get the months - in this case 1.7 months

So the answer is 5 years and 1.7 months

Illustration - Irregular Cash Flows

When the cash flows associated with an investment project change from year to year, the simple payback formula that we outlined earlier cannot be used. To understand this point, consider the following data:

When the cumulative cashflow becomes positive then this is when the initial payment has been repaid and so is the payback period

So in the final year we need to make $10 more to recoup the initial 800. So, that’s $10 out of $120. 10/120 x 12 (number of months) = 1.

So the answer is 4 years 1 month.

Advantages and Disadvantages of Payback

• Advantages of Payback include

  1) It is simple

  2) It is good to screen out projects that have very long payback periods

  3) Good if the organisation has poor cash flow

• Disadvantages of Payback include

  1) It ignores the time value of money

  2) It ignores cash after payback, after the project pays back, there may be very high cash flows, but these will be ignored