HOW TO CALCULATE PAY BACK PERIOD

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WHAT IS PAY BACK PERIOD?

Payback period is also known as payoff or pay-out method.

Pay back period is the time required to pay back the initial investment from earnings.

Pay back period is stateted in years and should not be stated in years and months.

Pay back period method evaluates how long it will take to pay backor recover the initial investements.

HOW IS PAY BACK PERIOD CALCULATED

NOW, there exists two types of investment, there is :

1.  An investment that returns  the same amount of cash inflows every year.

This type of investment rarely exist in real business environment, however, in such a scenario, Pay back period is calculated as under;

PAY-BACK PERIOD =          initial  cost  of investment            

                                                    cash inflow or annual returns


ILLUSTRATION.

MFN lLimited is consindering investion in Machine X. the initial cost of Machine X is KES. 25,000.The machine is expected to generate annual cash inflows of KES 10,000. If, the desired pay back period of the company is 3 years, advise the management whether to invest on machine X or not.

SOLUTION

As seen the above figure the pay back period is 2.5 years which is less than desired company's pay back period.

ADVICE. The management should invest in machine X since it has a shorter pay back period.

Decision creteria

Investment with shorter pay back periods are prefered than those with longer payback period. Think about it this way, every investor want his/ her money back as fast as possible.

2. Invest that yields uneven amout of returns every period.

- Investments will not yeild the same amount of returns every period but in most ideal and ussual scenarios, investments yield different amout of returns in different periods. For this case therefore, pay back period is calculated as under;


PAY BACK PERIOD =  NUMBER OF FULL YEARS     +      UNRECOVERED AMOUNT

                                        BEFORE FULL RECOVERIES           (CASH INFLOW  DURING THE                                                                                                                                                             YEAR  OF FULL RECOVERY)         

ILLUSTRATION

Falcony limited is planning to invest ksh 1,200,000 in project A. The prospective operating cash inflows of the project are as follows. The prospective operating cash inflows of the project are as follows.

Year    cashflow 

1            100,000

2            300,000

3            600,000

4             400,000

5            500,000

SOLUTION

Year    cashflow           cumulative cashinflow

1            100,000            100,000

2            300,000            400,000

3            600,000            1,000,000 

4             400,000           1,400,000  (this is the year of full recovery)

5            500,000             1,900,000


Pay-back -period  =     3    +     200,000        =   3.5 years

                                                  400,000

Notes

- At year 3 the cumulative amount  recovered is KES 1,000,000  the unrecovered amount

 ( 1,200,000 - 1,000,000 =  kes 200,000) , this amount is recovered during year of full recovery.



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