Payback Period (Cambridge (CIE) A Level Accounting): Revision Note

Payback period

What is the payback period of an investment?

• The payback period is the length of time it takes for an investment to recover its initial cost from net cash inflows

• Owners usually prefer investments which have a shorter payback period

• If payback exceeds a company's target payback period, the project should be rejected

How do I calculate the payback period?

• STEP 1
  Calculate the net cash flow for each year

• STEP 2
  Calculate the cumulative net cash flow for each year

  • The cumulative net cash flow for Year 0 is the same as its net cash flow

  • The cumulative net cash flow for Year 1 is the net cash flows for Year 0 and Year 1 added together

  • The cumulative net cash flow for Year 2 is the net cash flows for Year 0, Year 1 and Year 2 added together

  • The cumulative net cash flow for any year is equal to that year's net cash flow added together with all the previous net cash flows

• STEP 3
  Identify the first year when the cumulative net cash flow is positive

  • Call this the recovery year

• STEP 4
  Calculate the payback period

  • The number of years is the year before the recovery

    • If the recovery year is Year 4, this means the payback period is 3 years plus some additional days

  • The number of days is found using the formula

    • 

What are the advantages and disadvantages of the payback period method?

Advantages

• It is simple and quick to calculate

• It is easy for non-accountants to understand

• It is useful for businesses with liquidity concerns

• It reduces the risk

  • The shorter the payback, the less uncertainty

Disadvantages

• It ignores cash flows after the payback period

• It ignores the time value of money

• It does not measure overall profitability