Analysing the Payback Period when making an investment

Payback Period is the length of time required before the total of the cash inflows received from the project is equal to the original cash outlay i.e. the length of time the investment takes to return its initial capital. In yet another definition, it is the ratio of initial fixed investment over annual net cash flows. The decision criterion is that if the payback period is less than some minimal accepted payback period that is set as a threshold, the proposal is accepted. If the period is more than the cut-off period, the project is rejected. For ranking decisions, projects with shorter payback periods get preference over those that take longer. The following is the formula for calculating the payback period;

Payback period = Year before full recovery + Unrecovered cost at start of the year

Of the original investment Total cash flow in year

The payback criterion is a rough measure of risk. It reflects the liquidity of a project and therefore the more liquid the project the higher the chance of recovering the initial investment. A project with short payback period but with a low rate of return is preferred over projects with long payback period and high rate of return reason being that the firm may be in need of quick returns of its invested cash. This is the reason behind its preference by firms with liquidity problems.

Payback period is the investment appraisal method of choice for firms that produce products that are prone to obsolescence. Since these products last for only a year or two years, their payback period must be short for the firm to have recouped its initial capital. It is therefore preferred in situations when time is of relatively high importance.

The method is easy to understand and the calculation involves simplified steps. It only considers the net cash flows and cumulating them to determine when they equal the cost of the project. It automatically adjusts for the uncertainty of later cash flows by ignoring them. the main interest is only the initial capital and the time taken to that point hence cash flows generated after the payback period aren’t considered.

In spite of the above advantages, payback period has some drawbacks. The method fails to consider the cash flows after the payback period and consequently not ideal viable for measuring the actual profitability of a project. It also does not take into account the magnitude or timing of recoveries during the payback period and considers the recovery period as a whole. This is particularly bad since most investments tend to have lower cash flows in earlier years and higher cash flows as the project matures.

The payback period ignores the time value of money. This implies that it ignores financing costs of investments. Time value of money is essential in considering the productivity of a project because it considers present cash flows as equal to future ones. The method ignores the scale of investment and recommends an arbitrary cut-off point. There is no objectivity in establishing cut-off points across different firms thus bringing inconsistency. This is not to add that quick payback does not necessarily mean good investment.

The method discriminates against long-term projects such as research and development and new product development. These types of projects normally require huge initial outlays and take long to give returns and yet they are so critical to any firm interested in enhancing its competitiveness in the industry. In addition, it does not have an inherent mechanism to highlight differences in investment’s useful life. Such differences are very essential and relying on payback can lead to incorrect decisions.

Despite the disadvantages of the payback method, it is widely used in practice though often only as a supplement to more sophisticated methods. It is favored because of its simplicity and most investors take it as the conventional one.

Net Present Value

Net Present Value (NPV) is the difference between the value of an investment and its cost. It represents the economic worth of the project in terms of today’s dollar. A zero NPV means that the project cash flows are enough to repay the invested funds and provide the required rate of return on such capital. For positive NPV projects, excess cash accrues to shareholders and therefore their position is improved. Positive NPV projects result in an increase in the market price of ordinary shares while negative NPV projects cause erosion of shareholders’ wealth. It is calculated as;

Present value of future net cash flows (PV) – Initial investment (Io).

The decision a criterion is that if the sum of these discounted cash flows is equal or greater than zero the project is accepted. Otherwise, the project is not accepted. In the case of mutually exclusive projects, the project with the highest NPV if it is positive gets acceptance. That way, the shareholders’ wealth is boosted to a maximum.

Advantages

The method uses the relevant cost approach by concentrating only on incremental cash flows. It measures the shortfalls or excess of cash flows and assumes that the cash flows obtained are reinvested is at the present rate of return. This is more appropriate in conditions of capital rationing. The result represents increase to a shareholders’ wealth expressed in present-day terms.

The method considers the time value of money. This is important because cash flows obtained today are not the same as those obtained five years from now. This is because the method considers the time value of money and the relevant cash flows uses the cost of capital of the company as a discounting factor. Additionally, it considers cash flows for the entire project life. It is thus more comprehensive and reliable in appraising long-term projects.

However, the results and procedures involved in calculating NPV aren’t easily understood by nonprofessionals. The cost of capital is difficult to calculate especially due to the effect of inflation and the fact that some industries lack sufficient data to base their calculations. The method requires a detailed long-term forecast of a project’s cash flows, which is a very subjective exercise.

Twice limited should consider using NPV in their appraisal because as compared to other capital appraisals, it expresses in absolute terms the expected economic contribution of the project. Its results shows the present worth in future cash flows after discounting them with the firm’s cost of capital.

Assessing the five projects

Under the payback period, the five proposals for the new holiday are as follows.

Climb project

The initial investment is 1,760,000

Year Net cash flows Cumulative cash flows

2011 £1,040,000.00 1,040,000.00

2012 £ 780,000.00 1,820,000.00

2013 £ 520,000.00 2,340,000.00

Payback period = 1+ (1,760,000-1,040,000)/780,000

= 1.92 years

Paddle project

Initial investment is 1,640,000

Year Net cash flows Cumulative cash flows

2011 £ 770,000.00 770,000.00

2012 £ 770,000.00 1,540,000.00

2013 £ 770,000.00 2,310,000.00

Payback period = 2+ (1,640,000-1,540,000)/770,000

= 2.13 years

Rappel project

Initial investment is 1,130,000

Year Net cash flows Cumulative cash flows

2011 £ 740,000.00 740,000.00

2012 £ 240,000.00 980,000.00

2013 £ 590,000.00 1,570,000.00

Payback period = 2+ (1,130,000-980,000)/590,000

= 2.25 years

Swim project

Initial investment is 1,030,000

Year Net cash flows Cumulative cash flows

2011 £ 480,000.00 480,000.00

2012 £ 480,000.00 960,000.00

2013 £ 480,000.00 1,440,000.00

Payback period = 2+ (1,030,000-960,000)/480,000

= 2.15 years

Float project

Initial investment is 280,000

Year Net cash flows Cumulative cash flows

2011 £ 100,000.00 100,000.00

2012 £ 130,000.00 230,000.00

2013 £ 100,000.00 330,000.00

Payback period = 2+ (280,000-230,000)/100,000

= 2.5 years

The summary of project’s payback periods is as follows.

Project Number of years

Climb 1.92

Paddle 2.13

Rappel 2.25

Swim 2.15

Float 2.50

Based on the ranking decisions, Twice limited should accept and implement paddle holiday project. It has the shortest payback period and this means that the project will recover its initial cost within 1 year and 11 months.

Under NPV, the project’s net cash flows use the cost of capital as a discounting factor within the period of three years. The general calculation of NPV is Present value of future net cash flows (PV) – Initial investment (Io). The following are NPV of the proposals:

Climb project

Year 2011 2012 2013

Net cash flows £1,040,000.00 £ 780,000.00 £ 520,000.00

PVIF8%, 3 0.9259 0.8573 0.7938

PV 962,962.96 668,724.28 412,792.77

NPV = [962,962.96 + 668,724.28 + 412,792.77] – 1,760,000

= 284,480.01

Paddle project

Year 2011 2012 2013

Net cash flows £ 770,000.00 £ 770,000.00 £ 770,000.00

PVIF8%, 3 0.9259 0.8573 0.7938

PV 712,962.96 660,150.89 611,250.82

NPV = [712,962.96 + 660,150.89 + 611,250.83] – 1,640,000

= 344,364.68

Rappel project

Year 2011 2012 2013

Net cash flows £ 740,000.00 £ 240,000.00 £ 590,000.00

PVIF8%, 3 0.9259 0.8573 0.7938

PV 685,185.18 205,761.31 468,361.02

NPV = [685,185.19 + 205,761.32 + 468,361.02] – 1,130,000

= 229,307.52

Swim project

Year 2011 2012 2013

Net cash flows £ 480,000.00 £ 480,000.00 £ 480,000.00

PVIF8%,3 0.9259 0.8573 0.7938

PV 444444.44 411522.63 381039.47

NPV = [444,444.44 + 411,522.63 + 381,039.47]- 1,030,000

= 207,006.55

Float project

Year 2011 2012 2013

Net cash flows £ 100,000.00 £ 130,000.00 £ 100,000.00

PVIF8%, 3 0.9259 0.8573 0.7938

PV 92592.59 111454.04 79383.22

NPV = [92,592.59 +11,454.04 + 79,383.22]

= 3,429.86

Twice limited should accept Paddle holiday project because it ranks the highest NPV of £ 344,364.68. This indicates that after proper analysis of the net cash inflow, paddle project would generate over the three the above value and shareholder’ wealth will be improved. According to the payback period, climb project has the shortest recovery period and if the company was only using it for capital appraisal, the Twice limited could accept. NPV is more realistic because it considers time value of money as it discounts the net cash flows. The result shows the present value of a particular project in present-day using future cash flows. NPV method is regarded as superior in terms of project appraisal and Twice limited have to accept paddle project and discard climb project as proposed by payback period.