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The Payback Period represents the amount of time that it takes for a Capital
Budgeting project to recover its initial cost. The use of the Payback Period as a
Capital Budgeting decision rule specifies that all independent projects with a
Payback Period less than a specified number of years should be accepted.
When choosing among mutually exclusive projects, the project with the
quickest payback is preferred.
Cash
Year
Flow
0 -1000
1 500
2 400
3 200
4 200
5 100
To begin the calculation of the Payback Period for project A let's add an
additional column to the above table which represents the Net Cash Flow
(NCF) for the project in each year.
Payback Period
Payback Period = 2 + (100)/(200) = 2.5 years
Thus, the project will recoup its initial investment in 2.5 years.
As a decision rule, the Payback Period suffers from several flaws. For instance,
it ignores the Time Value of Money, does not consider all of the project's cash
flows, and the accept/reject criterion is arbitrary.
Example Problems
Find the Payback Period for the project with the
following cash flows.
Year Cash Flow
0 $
1 $
2 $
3 $
4 $
5 $
Payback: years