Capital Budgeting Evaluation Techniques^113
Payback PeriodPayback period is the most widely used technique and can be defined as the number of
years required to recover the cost of the investment. This is easy to calculate, but is
often calculated before tax, and always after accounting depreciation. By definition,
the payback period ignores income beyond this period, and it can thus be seen to be
more as a measure of liquidity than of profitability.
The payback period is the length of time required to recover the initial cash outlay on
the project. For example, if a project involves a cash outlay of Rs 6,00,000 and generates
cash inflows of Rs 1,00,000, Rs 1,50,000, Rs 1,50,000 and Rs 2,00,000 in the first,
second, third and fourth years respectively, it payback period is four years because the
sum of cash inflows during four years is equal to the initial outlay. When the annual
cash inflow is a constant sum, the payback period is simply the initial outlay divided by
the annual cash inflow. For example, a project which has an initial cash outlay of Rs
10,00,000 and constant annual cash inflow of Rs 3,00,000 has a payback period of Rs.
10,00,000/Rs 3,00,000 = 3.1/3 years.
According the payback criteria, the shorter the payback period, the more desirable the
project. Firms using this criterian, generally specify the maximum acceptable payback
period. If this is n years, projects with a payback period of n years or less are deemed
worthwhile, and projects with a payback period exceeding n years are considered
unworthy.
Projects with long payback periods are characteristically those involved in long range
planning, and which determine a firm's future. However, they may not yield their highest
returns for a number of years and the result is that the payback method is biased
against the very investments that are most important to long term success.
EvaluationA widely used investment criterion, the payback period seems to offer the following
advantages.
l It is simple, both in concept and application. It does not use comlex concepts and
tedious calculations and has few hidden assumptions.
l It is a rough and ready method for dealing with risk. It favours projects which
generate substantial cash inflows in earlier years and discriminates against projects
which bring substantial cash inflows in later years but not in earlier years. Now,
if risk tends to increase with futurity - in general, this may be true - the payback
criterion may be helpful in weeding out risky projects.
l Since it emphasises earlier cash inflows, it may be a sensible criterion when the
firm is pressed with problems of liquidity.