The Payback Method

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1. The Payback “Signal”

1. The Payback method is not really an analysis on the financial performance for a
capital investment. Payback is much more focused on the financial risk for a
capital investment.
2. By measuring the amount of time it takes for the original net cash investment to
be recovered (i.e., paid back), the Payback method provides important
information on the exposure and flexibility characteristics of the investment.
1. The longer it takes for the net cash investment to be recovered, the more
exposed the organization is to economic and operating events that can
negatively affect the capital project. Reducing exposure (by reducing the
Payback period) effectively reduces the risk of harmful future events
affecting the organization's investment.
2. The longer it takes for the net cash investment to be recovered, the less
flexibility the organization has to use its resources to explore and invest in
other opportunities. Increasing flexibility (by reducing the Payback period)
effectively reduces the risk of missing out on desirable future events in
which the organization may want to invest.
3. In summary, the Payback method is a signal on the financial risk of a capital
investment. In contrast, by reporting on the net present value of earnings and on
the rate of return, NPV and IRR (respectively) provide important signals on the
financial performance of a capital investment. Both types of perspectives are
important in capital budgeting decisions.

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2. Payback Method—Even Cash Flows
1. The basic Payback concept is a simple formula:

InvestmentCash Flow

2. For example, if net cash investment is $1,500,00 and $400,000 is the annual net
operating cash flow, then Payback would be:

$1,500,000$400,000=3.75

3. The Payback measure of 3.75 represents 3.75 periods of time before the
investment is recovered. Since these are annual cash flows, then Payback in this
example is 3.75 years. However, be sure to understand that the number of periods
the Payback represents is based on the length of time of an operating cash flow.
For example, if the $400,000 represents monthly cash flows, then the Payback
would be 3.75 months (i.e., approximately 3 months and 3 weeks).
4. The Payback solution can be represented visually on a timeline. For the example
above, the timeline solution looks like this:

5. Note the Payback method assumes that cash flows take place evenly throughout
the operating period, rather than at the end of the period. In the example above,
the 3.75 solution indicates that the investment is fully recovered by October 1 of
the third year. This can be true only if operating cash flows take place at least by
the end of each month. Remember an assumption in previous lessons using NPV
and IRR methods was that cash flow takes place at the end of each period (e.g.,
each year). Be sure to pay attention to when cash flows actually take place in the
exam problem or in your organization, and adjust your capital budgeting analysis
accordingly.

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3. Payback Method—Uneven Cash Flows
1. Most operating processes do not produce constant levels of net cash flows each
period of time. Realistically, most operating cash flows are uneven from period to
period, and this complicates the Payback computation approach.
2. With uneven operating cash flows, a simple single-step math solution is not
available. Instead, the cash flow in each operating time period needs to be
individually evaluated to determine if and when the net cash investment is
recovered.
3. For example, consider a situation similar to our Payback example above (which
also results in total future cash flows of $2,000,000). Note, though, that in this
case the cash flows are uneven as represented in the timeline below:

4. Note in the timeline above that the Payback solution is 4.17 years. The solution
approach is a year-by-year analysis. For example, the operating cash flow in Year
1 is $200,000. By the end of Year 1, the net cash investment has been paid down
to $1,300,000 (= $1,500,000 – $200,000), which is also represented in the
timeline above. Similarly, by the end of Year 2, the investment has been paid
down to $1,000,000 (= $1,300,000 – $300,000).
1. By the end of Year 4, there is only $100,000 remaining to be paid back on
the original investment. Assuming operating cash is flowing throughout the
year, then we can compare the remaining cash to be recovered at the end of
Year 4 to the total cash flow in Year 5, and estimate that the payback takes
place approximately 0.17 into Year 5 (0.17 = $100,000 ÷ $600,000),
resulting in a Payback solution of 4.17 years.
2. Typically, organizations don't try to specify the payback as precisely as 4.17
years. More likely, the organization might round off the payback to a
number like 4.2, which places the payback event sometime in the month of
March in Year 5.

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4. Payback Method—Discounted Cash Flows1
1. Look again at the timeline in our last Payback example and notice that by the end
of the investment's life, there remains $500,000 cash flow above and beyond the
original investment. The key question is, does this $500,000 represent the long-
term profit of the investment? Remember what you know about the time-value of
money. Spending $1,500,000 and then waiting nearly five years before seeing
positive overall cash flow does not feel like a $500,000 profit on the investment!
Due to the time value of money, the future cash flows are not directly comparable
to the original investment. These cash flows need to be discounted back to present
value before making the comparison.

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2. Return back to the first Payback example with even cash flows of $400,000 each
year. Note that the excess cash after the Payback at 3.75 years is also $500,000.
Let's work with the example based on even cash flows. Using your business
calculator, you can discount back to present value each of the future cash flows
before using those discounted cash flows to compute the Payback solution. Using
the example above with uneven cash flows, and assuming a discount rate of 8%,
compute the present value of each cash flow as follows:
1. On various editions of the Hewlett-Packard™ 10Bii+, complete the
following key strokes:
[Gold shift], [C ALL] → to clear all memory
8, [I/YR] → to enter 8% as the annual discount rate
1, [N] → to enter Period 1 (Year 1) in the analysis.
400000, [FV] → to enter $400,000 as the future cash inflow at end of
Period 1.
[PV] → returns the present value of this future cash flow.
Display: −370,370 → this is the present value of the
$400,000 cash flow in Year 1
Do not clear the memory!
2, [N] → to enter Year 2 in the analysis (note that the FV is still
$400,000).
[PV] → returns the present value of this future cash flow.
Display: −342,936 → this is the present value of the
$400,000 cash flow in Year 2
3, [N] → to enter Year 3 in the analysis.
[PV] → returns the present value of this future cash flow.
Display: −317,533 → this is the present value of the
$400,000 cash flow in Year 3
4, [N] → to enter Year 4 in the analysis.
[PV] → returns the present value of this future cash flow.
Display: −294,012 → this is the present value of the
$400,000 cash flow in Year 4
5, [N] → to enter Year 5 in the analysis.
[PV] → returns the present value of this future cash flow.
Display: −272,233 → this is the present value of the
$400,000 cash flow in Year 5
2. On various editions of the Texas Instruments™ BA II Plus, the
keystroke sequence is similar.
Remember [2nd], [CLR TVM] to clear memory of all time value of
money computations.
Remember [CPT], [PV] to compute the present value of each future
cash flow.

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3. The result of discounting each of the future even cash flows is to create an uneven
cash flow analysis when performing the Discounted Payback computation. The
timeline below demonstrates the solution. Each of the nominal operating cash
flows ($400,000 annual) are represented with the individual discounted cash
flow amount right below.

4. Note at the end of Year 1 there remains $1,129,630 “real” dollars to be paid back
on the original investment (= $1,500,000 – $370,370), and this computation
continues forward year-by-year. Year 4 ends with $175,149 remaining in real
(present value) dollars to be paid back on the investment, and a $272,233 present
value cash flow in Year 5. The ratio of these two numbers ($175,149 ÷ $272,233)
is 0.64, which means that the Discounted Payback is 4.64 years. In other words,
the original investment is fully recovered in real dollars approximately sometime
in the month of August in Year 5.
5. Note that the excess real (present value) cash after the Payback at 4.64 years is
$97,084. This actually represents the net present value after the investment is
paid back. In other words, this is the NPV you would compute on your calculator
based on comparing the $1,500,000 initial investment to five years of $400,000
cash flows at an 8% discount rate. Try it on your calculator! As you can see, the
Discounted Payback method is now providing insight similar to the NPV method
regarding the financial performance of the investment.
1. In this regard, the Payback method is now shifting the focus of the analysis
from assessing the risk of returning nominal dollars to focus on assessing
the performance of the investment in terms of real dollars.
2. Sometimes the Discounted Payback method is referred to as an “improved”
method because it incorporates the time value of money. That being said,
NPV and IRR methods are more efficient and more effective in analyzing
discounted cash flows, and are the recommended approach for assessing
financial performance. Hence, in practice the Payback method is usually
based on nominal dollars and is viewed as a reasonably effective way to
assess the exposure and flexibility (i.e., risk) of the nominal cash
represented in the original investment.

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 5. Advantages and Disadvantages of the Payback Method
1. Remember that the Payback method, when it is based on nominal (undiscounted)
cash flows, is primarily focused on financial risk analysis. By comparison, more
traditional discounted cash analysis methods like NPV and IRR are focused on
financial performance analysis.
2. The traditional (i.e., undiscounted cash flow) Payback method has the following
advantages compared to the discounted cash flow methods like NPV and IRR:
1. Payback addresses a common, and often crucial, issue in business
investment, which is the “time to money” issue. In other words, how long
does it take to return the original investment? This is often an important
focus in capital budgeting analysis.
2. As described in the beginning of this lesson, by knowing the “time to
money” (i.e., the time needed to recover the investment), managers are able
to consider the exposure of the investment to negative events in the future.
Managers are also able to consider the flexibility of the investment to have
money available in the future to consider other investment opportunities.
3. The traditional Payback method has the following disadvantages compared to the
NPV and IRR methods:
1. The Payback method does not distinguish money today from money
tomorrow. In other words, it does not consider the time value of money.
We've demonstrated, however, that this concern can be addressed based on
the needs of managers.
2. More importantly, the Payback method pays no attention to “value” created
past the Payback point. In other words, once the investment hits the
Payback point, any additional cash flow is not factored into the analysis. For
example, consider our original Payback example with five years of even
operating cash flows at $400,000. The Payback was 3.75 years. What if the
investment actually had six, seven, or even more years of operating cash
flows? That added value in the investment doesn't change the Payback
solution, as demonstrated below. This is a significant limitation of this
capital budgeting method.

Cole, Inc. is considering an $800,000 investment with a three–year life and expects the
following annual operating cash flows:
Year 1: $325,000
Year 2: $375,000
Year 3: $400,000

Cole's cost of capital is 12%.

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What is the traditional Payback on this investment? What is the Discounted Payback on this
investment?

Answer

Traditional Payback

Year 1: $800,000 – $325,000 = $475,000 remaining to be recovered

Year 2: $475,000 – $375,000 = $100,000 remaining to be recovered
Year 3: $100,000 ÷ $400,000 = 0.25 years
Traditional Payback = 2.25 years

Discounted Payback

For example, on a Hewlett-Packard™ business calculator, complete the following key

strokes:
[Gold shift], [C ALL] → to clear all memory
12, [I/YR] → to enter 12% as the annual discount rate
1, [N] → to enter Period 1 (Year 1) in the analysis.
325000, [FV] → to enter $325,000 as the future cash inflow at end of Period 1.
[PV] → returns the present value of Year 1 cash flow 290,179 (rounded).
2, [N] → to enter Year 2 in the analysis
375000, [FV] → to enter $375,000 as the future cash inflow at end of Period 2.
[PV] → returns the present value of Year 2 cash flow 298,948 (rounded).
3, [N] → to enter Year 3 in the analysis.
400000, [FV] → to enter $400,000 as the future cash inflow at end of Period 3.
[PV] → returns the present value of Year 3 cash flow 284,712 (rounded).

Year 1: $800,000 – $290,179 = $509,821 remaining to be recovered

Year 2: $509,821 – $298,948 = $210,873 remaining to be recovered
Year 3: $210,873 ÷ $284,712 = 0.74 years
Discounted Payback = 2.74 years

The Payback method provides an analysis of underlying risk in the capital investment,
especially with respect to exposure and flexibility in terms of recovering the initial net cash
investment. By dividing annual operating cash flows into the net investment, the Payback
method returns a measure that represents the periods of time required to recover the
investment. However, a straightforward ratio of investment to operating cash only works
with constant levels of operating cash flows. When cash flows are uneven, then the cash from
each operating period needs to be individually factored against the initial investment, and
periods of time summed until the Payback point is reached. One disadvantage of the Payback
method is that future cash flows are not discounted (i.e., brought back to present value)
before assessing the Payback point. This issue can be addressed by individually discounting
each future cash flow before factoring the cash flow against the initial investment. The results

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of the Discounted Payback method are similar to the NPV (net present value method),
although the Discounted Payback method is somewhat cumbersome compared to the NPV
method.

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