Chapter 11 The Basics of Capital Budgeting 35311-8 PAYBACK PERIOD
NPV is the most commonly used method today; but historically, the! rst selection
criterion was the payback period, de! ned as the number of years required to
recover the funds invested in a project from its operating cash " ows. Equation 11-3
is used for the calculation, and the process is diagrammed in Figure 11-7. We start
with the project’s cost, a negative, and then add the cash in" ow for each year until
the cumulative cash " ow turns positive. The payback year is the year prior to full
recovery plus a fraction equal to the shortfall at the end of that year divided by the
cash " ow during the full recovery year:^19
Payback!
Number of
years prior t o
full recovery"Unr ecover ed cost
at start of year____ Cash " ow (^) during
full recovery year
11-3
The shorter the payback, the better the project. Therefore, if the! rm requires a
payback of three years or less, S would be accepted, but L would be rejected. If
the projects were mutually exclusive, S would be ranked over L because of its
shorter payback.
Payback Period
The length of time required
for an investment’s net
revenues to cover its cost.
Payback Period
The length of time required
for an investment’s net
revenues to cover its cost.
SEL
F^ TEST Describe in words how an NPV pro" le is constructed. How are the intercepts
of the x- and y-axes determined?
What is the crossover rate, and how does its value relative to the cost of
capital determine whether a con# ict exists between NPV and IRR?
What two characteristics can lead to con# icts between the NPV and the
IRR when evaluating mutually exclusive projects?
(^19) Equation 11-3 assumes that cash $ ows come in uniformly during the full recovery year.
Payback Calculations
F I G U R E 1 1! 7
Project L Years
Cash #ow
Cumulative cash #ow
Payback L = 3 + 200/675 =
675
475
400
! 200
300
! 600
100
! 900
!1,000
!1,000
3.30
0 1 2 3 4
Years 0Cash #ow
Cumulative cash #owPayback S = 2 + 100/300 =Project S 4100
300