We can see that the payback period is either five years if cash flows arise at the end of the year or four years and (5,000/17,500 x 12) three months (to the nearest month) if cash flows arise during the year.
Payback is often used as a first screening method for an investment – ie the first question that is often asked with a new project is: ‘When will the initial cost be paid back?’ An organisation may have a target payback period, with any project taking longer than the target period being rejected.
Payback also provides more focus on the earlier cash flows arising from a project, as these are both more certain and more important if an organisation has liquidity concerns.
Two other advantages are that payback is easy to calculate and to understand.
There are, however, disadvantages associated with the payback method of investment appraisal:
- Cash flows after the payback period are ignored, therefore the effect of the whole project on the cash flows of the organisation are not considered.
- A target is required, which can be difficult to set and is arbitrary.
- The increase / decrease in wealth of the investor arising from the project is not considered – the net present value of the project would need to be calculated to assess the effect on shareholder wealth, for example.
- The time value of money is not considered.
This last disadvantage will be overcome if the discounted payback is calculated rather than the payback period.
The discounted payback is defined as the length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment.
The discounted payback calculation takes into account the time value of money by discounting each cash flow before the cumulative cash flow is calculated, and determines the time at which the net present value becomes positive.
Let’s use the first example, but expand it by including the fact that the organisation has a cost of capital of 10%.
Again, the first step would be to ensure that the cash flows are identified, which we have already done – $17,500 per year.
The second step is to complete the cumulative cash flow table, but now extra columns are required for the discount factor and the discounted cash flow: