Payback Period Method

This method is used to derive the time period in which the cost of the project will be recovered. The payback period (P) is defined as the ratio of initial investment (I) to annual cash flows (C). Thus:

                        P=1/c

If a machine costs Rs 100, has a five-year life, and will have five uniform annual cash flows of Rs 40 each, the payback will be

100/40 = 2.5

In other words, the investment will be repaid in two and one-half years. Using the numbers given, which are not uniform from year to year, we add successive annual cash flows until they equal the initial outlay:

25 + 35 + 40 = 100

Payback is in three years. A short payback period will be required by management of a risk adverse company since the entire investment is repaid in two to three years.

The major drawback of the technique is that time value of money is not considered. Cash flows after the payback are not counted. In the example, the last two years of cash flows are not accounted for. The five-year project is certainly more desirable, with potential of two additional cash flows. 

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