In order to analyze whether the investments projects are worthwhile from financial point of view, we use various investment appraisal techniques and Payback period is one of them. PBP actually calculates how many periods, the projects takes to repay its initial investment.
How to Calculate PBP
The process is very simple as follows:
Determine the cash flows for each financial period,
At the end of each financial year, running balance is calculated of the cash position.
The running balance is calculated till the time when cash flows turns into positive figure.
Example
TDC is a soap detergent manufacturing company. Due to increased demand in the market, it is thinking to expand its existing production plants to increase production capacity by 30 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. But to do this, it has to incur $ 100,000 as initial investment. This will result in positive cash flows of 100,000, 200,000, 300,000, 4500,000 & 200,000 in 1st, 2nd, 3rd, 4th and 5th year of its becoming operational.
Required
Evaluate this investment decision using Pay Back Period method.
Solution
| Year | Cash Flows | Cumulative Cash Flows | Payback? |
| 0 | (1000,000) | (1000,000) | No |
| 1 | 100,000 | (900,000) | No |
| 2 | 200,000 | (700,000) | No |
| 3 | 300,000 | (400,000) | No |
| 4 | 450,000 | 50,000 | Yes |
| 5 | 200,000 | 250,000 |
As it is clear from the table above that the project is repaying its initial investment in Year 04 because cash flow is coming positive in the 4th year. So, it is worthwhile to start working over expansion project over the basis of PBP because just 04 years is not that much long period of time.