Payback period is a non-discounted capital budgeting technique or investment appraisal method, which helps financial analysts and managers to decide whether to undertake investment projects. In payback period method the project which pays back its initial investment within a time shorter than the estimated expected time benchmark or the project with the shortest payback period among mutually exclusive projects is undertaken.
In payback period method the initial investment cash outflow is defrayed using the projected future cash inflows and outflows to determine the time period it will take to recover the initial invested cash amount. Mandy is expected to invest US dollar $100, 000 in buying machine “A” or machine “B”. The expected cash flows from the two machines are shown as follow;
| year | cashflows machine “a” | investment balance owing to mandy from project “a” | cashflows machine “b” | investment balance owing to mandy from project “b” |
| 0 | -100,000 | 100,000 | -100,000 | -100,000 |
| 1 | 25,000 | 75,000 | 45,000 | -55,000 |
| 2 | 15,000 | 60,000 | 55,000 | 0 |
| 3 | 20,000 | 40,000 | 20,000 | 20,000 |
| 4 | 40,000 | 0 | -24,000 | -24,000 |
| 5 | 128,000 | 128,000 | 16,000 | 12,000 |
From the above table calculations, it can be determined that project “A” payback period is four years while project “B” payback period is two years. Project “B” should therefore be adopted or undertaken over project “A” as it pays back the initial investment faster than project “A”. This however reveals a great problem with payback period method as it can be noted in years five the net return of project “A” of US dollar 128,000 is greater than that of project “B” US dollar 12,000 which was undertaken. Another problem with PBP method is that it does not consider the increment in cash flows over time due to the interest rates or discount factors.
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