The payback period is the expected number of years of operation required to recover an initial investment. When project cash flows are discounted using an appropriate cost of capital, the discounted payback period is the expected number of years required to recover the initial investment from discounted net cash flows. Payback period calculation is quick and easy using actual or discounted net cash flows. In equation form, the payback period is
Payback Period = Number of Years to Recover Investment
The payback period can be thought of as a breakeven time period. The shorter the payback period, the more desirable the investment project. The longer the payback period, the less desirable the investment project.
To illustrate, consider the SVCC capital investment project discussed earlier. Table 15.4 shows net cash flows per year over the entire 8-year planning period in nominal dollars, as well as in dollars discounted using the firm's 15 percent cost of capital. In nominal dollars, the total amount of investment is $25.8 million, which is the sum of the dollar outlays given in the first three rows of column 2. As shown in the third row of column 3, a negative $25.8 million is also the cumulative value of the nominal net cash flow as of the end of year 2, just prior to the beginning of plant operations. When the nominal cash outlay of $25.8 million is discounted using the firm's 15 percent cost of capital, the present value of the investment cash outlay is $20,254,820, the sum of discounted cash outlays given in the first three rows of column 5. As shown in the third row of column 6, a negative $20,254,820 is also the cumulative value of net discounted cash flow as of the end of year 2, just prior to the beginning of plant operations.
Based on nominal dollar cash outflows and inflows, the payback period is completed between the end of year 5, when the cumulative net nominal cash flow is a negative $2,490,280, and the end of year 6, when the cumulative net nominal cash flow is a positive $5,652,843. Using nominal dollars, the payback period in years is calculated as
Nominal Payback Period = 5.00 + $2,490,280/$8,143,123
Based on cash outflows and inflows discounted using the firm's 15 percent cost of capital, the payback period is completed between the end of year 7, when the cumulative net discounted cash flow is a negative $169,717, and the end of year 8, when the cumulative net discounted cash flow is a positive $7,732,321. Using discounted net cash flows, the payback period in years is calculated as
Discounted Payback Period = 7.00 + $169,717/$7,902,039
Of course, these payback period calculations are based on the typical assumption that cash inflows are received continuously throughout the operating period. If cash inflows are received only at the end of the operating period, then the nominal payback period in this example would be 6 years and the discounted payback period would be 8 years. The exact length of the payback period depends on underlying assumptions concerning the pattern of cash inflows.
Note that the payback period is a breakeven calculation in that if cash flows come in at the expected rate until the payback year, the project will break even in an accounting sense. However, the nominal payback period does not take into account the cost of capital; the cost of the debt and equity used to undertake the project is not reflected in the cash flow calculation. The discounted payback period does take account of capital costs—it shows the breakeven year after covering debt and equity costs. Both payback methods have the serious deficiency of not taking into account any cash flows beyond the payback year. Other capital budgeting decision rules are more likely to lead to better project rankings and selections. The discounted payback period, however, does provide useful information about how long funds will be tied up in a project. The shorter the discounted payback period, the greater the project's liquidity. Also, cash flows expected in the distant future are generally regarded as riskier than near-term cash flows. Therefore, the discounted payback period is a useful but rough measure of liquidity and project risk.
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