The Payback (Payout) Period Method

By: Mark Anthony R. Agbayani MSE 40 Engr. Millare

Payback Method: Its Definition

y it refers to the time required to recover the initial

investment or the initial cash outlay as it is called in financial terms. y One of the oldest and most widely used methods to evaluate a capital investment proposal. y It mainly indicates a projects liquidity (marketability) rather than its profitability (success factor). y It is used to calculate the number of years required for cash inflows to just the equal cash outflows.

The Payback Method: Equation

y The formula or equation for the calculation of

payback period is as follows:

U

(R  E )  I u 0
k k k !1

y Wherein:

Rk =excess of receipts over expenses in period k Ek= excess of expenditures over receipts in period k I = Investment = payback period

y Note: when

= N (project life), the market value is included in the determination of the payback period. y For Discounted payback period :
U

(R
k !1

 E k )( P / F , i %, k )  I u 0

y Where i = MARR, and I = Investment at present time

(k=0) y Most of the time the Payback Period Method Equation is simplified into this simple relationship: Payback period = Investment required / Net annual cash inflow

The Payback Method: Advantages and Disadvantages

y Advantages

Simple to compute Provides some information on the risk of the investment Provides a crude measure of liquidity y Disadvantages No concrete decision criteria to indicate whether an investment increases the firm's value Ignores cash flows beyond the payback period Ignores the time value of money Ignores the risk of future cash flows

The Payback Period Method: Examples

considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year. y Required: Calculate payback period. Which machine should be purchased according to payback method? Calculation: Machine A payback period = $15,000 / $5,000 = 3.0 years Machine B payback period = $12,000 / $5,000 = 2.4 years According to payback calculations, York Company should purchase machine B, since it has a shorter payback period than machine A.
y York company needs a new milling machine. The company is

Goodtime Fun Centers, Inc., operates many outlets in the eastern states. Some of thevending machines in one of its outlets provide very little revenue, so the company is considering removing the machines and installing equipment to dispense soft ice cream. The equipment would cost $80,000 and have an eight-year useful life. Incremental annual revenues and costs associated with the sale of ice cream would be as follows:
Sales Less cost of ingredients Contribution margin Less fixed expenses: Salaries Maintenance Depreciation Total fixed expenses Net operating income 27,000 3,000 10,000 40,000 $20,000 =========== $150,000 90,000 60,000

y The vending machines can be sold for a $5,000 scrap value. The company

will not purchase equipment unless it has a payback of three years or less. Should the equipment be purchased?