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    Payback SOlved Examples

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    Iqtadar Ali
    This document provides two examples of calculating payback period for projects with initial investments and expected annual cash flows. The first example shows a project with even cash flows each year, while the second has uneven cash flows each year. It then discusses the decision rule for choosing between projects based on payback period, as well as the advantages and disadvantages of using payback period as an evaluation method.

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    Payback SOlved Examples

    Uploaded by

    Iqtadar Ali
    248 views3 pages
    This document provides two examples of calculating payback period for projects with initial investments and expected annual cash flows. The first example shows a project with even cash flows each year, while the second has uneven cash flows each year. It then discusses the decision rule for choosing between projects based on payback period, as well as the advantages and disadvantages of using payback period as an evaluation method.

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    This document provides two examples of calculating payback period for projects with initial investments and expected annual cash flows. The first example shows a project with even cash flows each year, while the second has uneven cash flows each year. It then discusses the decision rule for choosing between projects based on payback period, as well as the advantages and disadvantages of using payback period as an evaluation method.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    248 views3 pages

    Payback SOlved Examples

    Uploaded by

    Iqtadar Ali
    This document provides two examples of calculating payback period for projects with initial investments and expected annual cash flows. The first example shows a project with even cash flows each year, while the second has uneven cash flows each year. It then discusses the decision rule for choosing between projects based on payback period, as well as the advantages and disadvantages of using payback period as an evaluation method.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 3

    Payback Solved Examples

    Examples
    Example 1: Even Cash Flows

    Company C is planning to undertake a project requiring initial


    investment of $105 million. The project is expected to generate $25
    million per year in net cash flows for 7 years. Calculate the payback
    period of the project.

    Solution

    Payback Period
    = Initial Investment ÷ Annual Cash Flow
    = $105M ÷ $25M
    = 4.2 years

    Example 2: Uneven Cash Flows

    Company C is planning to undertake another project requiring initial


    investment of $50 million and is expected to generate $10 million net
    cash flow in Year 1, $13 million in Year 2, $16 million in year 3, $19
    million in Year 4 and $22 million in Year 5. Calculate the payback value
    of the project.

    Solution

    (cash flows in millions)


    Year Annual Cumulative
    Cash Flow Cash Flow
    0 (50) (50)
    1 10 (40)
    2 13 (27)
    3 16 (11)
    4 19 8
    Payback Solved Examples
    5 22 30
    Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years

    Decision Rule
    The longer the payback period of a project, the higher the risk.
    Between mutually exclusive projects having similar return, the decision
    should be to invest in the project having the shortest payback period.

    When deciding whether to invest in a project or when comparing


    projects having different returns, a decision based on payback period
    is relatively complex. The decision whether to accept or reject a project
    based on its payback period depends upon the risk appetite of the
    management.

    Management will set an acceptable payback period for individual


    investments based on whether the management is risk averse or risk
    taking. This target may be different for different projects because
    higher risk corresponds with higher return thus longer payback period
    being acceptable for profitable projects. For lower return projects,
    management will only accept the project if the risk is low which means
    payback period must be short.

    Advantages and Disadvantages


    Advantages of payback period are:

    1. Payback period is very simple to calculate.


    2. It can be a measure of risk inherent in a project. Since cash flows
    that occur later in a project's life are considered more uncertain,
    payback period provides an indication of how certain the project
    cash inflows are.
    3. For companies facing liquidity problems, it provides a good
    ranking of projects that would return money early.
    Payback Solved Examples
    Disadvantages of payback period are:

    1. Payback period does not take into account the time value of
    money which is a serious drawback since it can lead to wrong
    decisions. A variation of payback method that attempts to
    address this drawback is called discounted payback
    period method.
    2. It does not take into account, the cash flows that occur after the
    payback period. This means that a project having very good cash
    inflows but beyond its payback period may be ignored.

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