The Payback period is the amount of time required to recover the initial business investment. The Payback period is a method of capital budgeting. While comparing two or more investments, the project managers and investors use this method to calculate the amount of time taken to recover the initial investment. Projects with shorter Payback period help investors earn profits easily, whereas projects with a longer payback period are the riskier ones.
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The payback method has the following advantages:
Listed below are some key takeaways from the payback period:
The formula for the calculation of payback period takes into consideration, the cash inflows from the project.
In case the cash inflows are even, then the formula for the calculation of the payback method is:
Payback period = initial investment/ net cash flow per period.
When the cash flow is uneven, the formula used for calculating the payback period is:
Payback period: A + B/C
A is the last period number where the cumulative cash flow is negative.
B is the absolute value of the cumulative net cash flows at the end of the period A.
C refers to the total cash inflow of the period following period A.
Cumulative cash flow means the sum of inflows to date, minus the initial cash flow.
A transportation company is considering the purchase of a dump truck that costs Rs 28.19 Lakhs and which would generate a net cash flow of Rs 7.2 Lakhs annually. The payback period for this investment is 4 years. The company is also considering the purchase of a long bed truck costing Rs 30.5 Lakhs and would generate an annual income of Rs 8.64 Lakhs. The payback period for this investment is 3.5 years. If the transport company has a budget constraint and is capable of investing in only a single venture at a time, and it’s using only the payback method of calculation for investment decisions, then the second option is considered to be more profitable due to a shorter payback period.
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