Finance - Investment
Theory 1 - Payback period - how long to recover our investment?
The payback period is one of the simplest tools for appraising different investment projects. To be able to compare projects we need to have information on how much the project costs and the expected net cash flows or income streams that it is likely to generate over its lifetime. Let's look at an example to see how to calculate it.
Let's say that a firm is thinking of installing a new computerised stock control system. The expected net cash flow (income less expenses) from the system is given in the table below. The cost of the system is 250,000.
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Net cash flow | 50,000 | 65,000 | 65,000 | 70,000 | 75,000 |
We can see that the payback period on this system is exactly four years. This is because after four years the returns total the original investment cost. If the figure does not come out as an exact number of years, then it is possible to work out instead the number of years and months - let's look at an example of this. In this case a firm is looking at buying a new automatic cutting machine. The cost of the machine is 100,000 and the expected net cash flows are:
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Net cash flow | 5,000 | 35,000 | 44,000 | 48,000 | 50,000 |
Looking at the figures, we can see that the payback period is between three and four years. After 3 years, the project has paid back 84,000 and so there is a further 16,000 needing to be paid back. In year 4, the expected cash flow is 48,000 and this is 4,000 per month, so it will take another 4 months to reach the return of 100,000. This means that the payback period is 3 years and 4 months.
Why not now have a look at the case study and practice using this technique?
