In order to aid managers in making decisions with regards to capital budgeting, tools and techniques have been devised. One of these methods is called the payback method. The payback method is one of the most popular tools in conducting capital budgeting decision.
The payback period tells the company the length of time required to recoup the original investment through investment cash flows. This is essentially the time when the company breaks even-the initial capital outlay is equal to the cash flows. For example, if a company invests $100,000 for the introduction of a new product line, then, the payback period reveals when the company will be generating cash flow of $100,000. Considering that the business organization invests in a project which generates the same level of cash flow annually, the payback period is computed as the follows:
However, if the investment generates unequal annual cash flows, then the individual annual cash flows are subtracted from the initial investment until a difference of zero is reached. The year when cash flow equals investment is the payback period.
Other things being equal, the investment with a low payback period is chosen as it implies less risk for the company. ...
As the investment is recouped in a shorter period of time, it also indicates that the investment is less likely to fail. In the payback method, the profitability of the investment is often tied on how fast the investment generates cash inflow for the business organization.
If the business organization is eyeing two or more projects to invest into, using the payback as sole decision criterion will make the company choose the project which has the lowest payback. However, if there is only one project to be evaluated, the firm often sets a specific span of time when the initial investment should be recouped. Generally, managers favor projects which have a payback period of less than three years. If the payback period is one year, the project is considered essential.
In order to assess really understand how the payback period can be used in decision making, we will use it to evaluate two projects-one which has a fixed annual cash flow and one which generates unequal stream of cash flow.
Suppose, XYZ Company is choosing between replacing its old machine used for production or embarking on a new product line. Each of the projects is estimated to require an initial investment of $100,000. Since the company is constrained with only $100,000 budget, the company must pursue only the more profitable option. The primary decision criterion used to evaluate investment decisions is the payback method. The estimated net cash flows are as follows:
Replace Old Machine
Introduce Product Line
A. Constant Annual Cash Flow
The replacement of the old machine with the new one is forecasted to yield