INTRODUCTION
TO CAPITAL BUDGETING 5-19
The investor expects to recover the initial investment of $25,000
sometime before the end of Year Three. The cumulative cash flow
at the end of Year Two is $16,000 and at the end of Year Three,
$26,000. Therefore, the payback period is more than two years but
less than three years.
We calculate the payback period by dividing the difference between the
initial investment and the cash flow in Year Two ($9,000) by the cash
flow in Year Three ($10,000) and adding the result to two years.
2 years + ($9,000/$10,000) = 2 + 0.9 = 2.9 years
Hurdle time for
payback period
The 2.9 years may also be expressed as 2 years and 47 weeks, by
multiplying 0.9 years by 52 weeks/year. Those companies that analyze
the payback period may have a hurdle time that must be met to invest in
the project. For example, if the investor in the example has a payback
hurdle of three years, s/he may consider investing in this project.
Problems with
payback period
methodology
The payback period methodology has some weaknesses. First, it does
not take into account the time value of money. Cash flows that will be
received in ten years are weighted the same as cash flows that will be
received in one year. Second, the payback period does not consider any
cash inflows that may occur after the hurdle time. A profitable
investment may be rejected because the cash flows will be received
after the hurdle time. Finally, it is often difficult to set an appropriate
hurdle time, especially if the cash flow pattern is not well-known to the
analyst.
The payback period methodology is a good beginning for analyzing a
potential investment, but it is not recommended as an analyst's key
tool for making investment decisions.