payback period.pptx
TRANSCRIPT
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Payback Period
Time period required to recover the costof the investment from the annualcash inflow produced by the
investment.
Amount investedExpected annual net cash inflow
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The Payback Period
Number of years needed to recover theinitial cash outlay of project.
Decision Rule: Project desirable if the
payback period is the firms maximumpayback period.
Shorter payback period is preferred whencomparing two projects.
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Cash Payback Period
5 years$130,000 $26,000/ =
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Casey Co. wantsto install a
machine thatcosts $16,000 andhas an 8-yearuseful life with
zero salvagevalue. Annual netcash flows are:
Year
Annual Net
Cash Flows
Cumulative
Net Cash
Flows
0 (16,000)$ (16,000)$1 3,000 (13,000)
2 4,000 (9,000)
3 4,000 (5,000)
4 4,000 (1,000)
5 5,000
6 3,000
7 2,000
8 2,000
Payback PeriodUneven Cash Flows
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Year
Annual Net
Cash Flows
Cumulative
Net Cash
Flows
0 (16,000)$ (16,000)$1 3,000 (13,000)
2 4,000 (9,000)
3 4,000 (5,000)
4 4,000 (1,000)
5 5,000
6 3,000
7 2,000
8 2,000
4.2
Payback PeriodUneven Cash Flows
We recover the $16,000purchase price between
years 4 and 5, about4.2 years for thepayback period.
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Using the Payback Period
Consider two projects, each with a 5-year lifeand each costing $6,000.
Project One Project Two
Net Cash Net CashYear Inflows Inflows
1 2,000$ 1,000$
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000
Would you invest in Project One just because
it has a shorter payback period?
Payback = 3 years Payback = 5 years
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6.2 The Payback Period Rule
How long does it take the project topay back its initial investment?
Payback Period = number of years to
recover initial costs Minimum Acceptance Criteria:
set by management
Ranking Criteria: set by management
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The Payback Period Rule(continued) Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the paybackcriteria may not have a positive NPV
Advantages: Easy to understand
Biased toward liquidity
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Payback Period
The payback method simply measureshow long (in years and/or months) it takesto recover the initial investment.
The maximum acceptable payback period
is determined by management. If the payback period is less than the
maximum acceptable payback period,accept the project.
If the payback period is greater than themaximum acceptable payback period,reject the project.
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Pros and Cons of PaybackPeriods The payback method is widely used by
large firms to evaluate small projects andby small firms to evaluate most projects.
It is simple, intuitive, and considers cashflows rather than accounting profits.
It also gives implicit consideration to thetiming of cash flows and is widely used as a
supplement to other methods such as NetPresent Value and Internal Rate of Return.
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Pros and Consof Payback Periods (cont.)
One major weakness of the paybackmethod is that the appropriate paybackperiod is a subjectively determined number.
It also fails to consider the principle ofwealth maximization because it is notbased on discounted cash flows and thusprovides no indication as to whether aproject adds to firm value.
Thus, payback fails to fully consider thetime value of money.
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Payback Period Example
Ex: Project with an initial cash outlay of $20,000 with following free cashflows for 5 years.
Payback is 4 years.
YEAR CASH FLOW BALANCE1 $ 8,000 ($ 12,000)
2 4,000 ( 8,000)
3 3,000 ( 5,000)
4 5,000 05 10,000 10,000
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Payback period
Benefits: Uses cash flows rather than accounting profits
Easy to compute and understand
Useful for firms that have capital constraints
Drawbacks: Ignores the time value of money
Does not consider cash flows beyond thepayback period.
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Discounted Payback Period
The discounted payback period is similar tothe traditional payback period except that ituses discounted free cash flows.
Discounted payback period: the number ofyears needed to recover the initial cashoutlay from the discounted free cash flows.