Companies often use the payback method when making capital budgeting decisions to establish a maximum acceptable period.
Let’s look at an example:
Butterflies Inc. is a small firm who’s worried about how soon they can recover their initial investment from the Caterpillar Project’s expected future cash flows. The CEO has provided the expected net cash flows and wants you to find the payback period.
|Year||Expected Cash Flow|
Calculate Cumulative Cash Flows
Since the payback periods shows how long it will take until the project covers it’s initial investment, we need to find the cumulative cash flow by adding each year’s cash to the sum of the previous year. This essentially reflects the cost of the investment that is yet uncovered from each annual cash flow.
|Expected Cash Flow||Cumulative Cash Flow|
Find Payback Period
Now we turn our attention to the year when our project breaks even. We do this by dividing the cumulative cash from the year previous to the break even point by the cash flow received during the break even year.
- Conventional payback period: $3,300,000 / 1 + $4,675,000 = 1.71 Years
The general takeaways are:
- The payback period indicates the time period at which the project breaks even
- The conventional payback period ignores the time value of money and should sometimes be supplemented with the discounted payback period.