Payback period method is the simplest of the measures used in analyzing investments which refers to the time period required to recover the initial cost. However as there are no formulas to find the payback period thus it makes it hard to find the PP. Here, me Abraham A. will take you on a guided tour to define, explain and illustrate example calculation of simple payback period.
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Finding simple payback period with paper and pencil is a time consuming task, we will save you the time and headache by offering you software tools such as Excel worksheet function and Windows 7 & 8 calculator that will help find the regular payback period with relative ease. Follow the links shown below for more information
Investment appraisal is carried out with the aid of various financial measures to find an investor's return on investment. Here, we will explore and explain PP which is one of the DCF techniques used for analyzing investment. A definition of payback period will be given, followed by PP formula that is later used in an example calculation to find the payback period. I will also brief you about an Excel function that may be used to solve for the payback period when you type in the Excel formula in a worksheet cell.
Payback period is defined as the time interval needed to regain or recover the initial cost that were paid when making an investment. An individual investor or a corporation that is planning to either purchase new equipment, machinery, land, a manufacturing plant has to know whether there will be any returns from investing. In this respect, a simple payback period will help a corporate manager to compare it against the target time that was set aside by managers or directors of the company. The acceptance criteria will dictate that an investment is worthwhile if it takes less time than the one that was set as a target.
We can use the following TVM equation to solve for N which will be our payback period. The C denotes the cost paid at present, the B is the periodic income and SAL is the salvage value.
C + B x N + SAL = 0
C + B x N = -SAL
B x N = -[SAL + C]
N = -[SAL + C]/B
The formula listed above will do the job only when the series of incomes and costs are in uniform amounts. When you have a series of uneven cash flows, then we are short on having any math formula that finds the payback period. In such cases, we will resort to making use of step-by-step procedure to find the year before recovery and find the remaining part of the payback period.
Now we will show you example calculation of simple payback period using the PP formula listed in the last section. Assume that you invest $10,000 at present and expect to make $3,000 each year, and the investment has no salvage value. You are tasked with finding the simple undiscounted payback period as shown below.
N = -[0 + -10,000]/3,000
N = -[-10,000]/3,000
N = 10,000/3,000
N = 3.333
When we have a set of uneven cash flows, we can make use of tables to find the payback period for such irregular cash flows. As an example, if we made an investment of $10K and were to receive $5K, $4K, $3K and $1K for each of the next 4 years. We will use the following table where the cumulative cash flows turn positive in year 3, thus year before recovery is 2 and we find the remaining payback period as follows:
PP = 2 + [$3K - $2K]/$3K
= 2 + $1K/$3K
= 2 + $1K/$3K
= 2 + 0.333
PP = 2.333
|T||Cash flow||Cumulative Cash flow|
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