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Cash Payback Method:

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Learning Objectives of this article:

  1. Define and explain cash payback method of capital investment evaluation.
  2. How is it calculated?
  3. What are the advantages and disadvantages of this method?

Contents:

Definition and Explanation:

Cash payback method (also called payback method) is a capital investment evaluation method that considers the cash flows as well as the cash payback period. Cash payback period is the expected period of time that will pass between the date of an investment and the full recovery in cash or equivalent of the amount invested. Under average rate of return method, analysts focus on incremental income from an investment. But cash payback method focuses on the cash flows rather than accounting income.

Accounting income is not the same as cash flows, because the accounting income includes accruals and deferrals. Many analysts prefer using cash flows in evaluating investment proposals because the ultimate sacrifices and benefits of any capital decision eventually are reflected in cash flows. Very simply, the capital investment uses cash, and must therefore return cash in the future in order to be successful.

The amount as well as the timing of the cash flows influences the calculation under the cash payback and present value methods. Thus, a cash flow orientation is required when using payback and present value methods. Cash flows consist of cash outflows and cash inflows. The difference between cash inflow and cash outflow for any single period is called net cash flow.

Formula:

Payback period is equal to the time required to recover the initial outlay for the plant asset. It is calculated by the following formula:

Cash payback period = Initial investment / Net cash flow

Example:

Assume that the proposed investment in a plant asset with an 8 year life is $200,000. The annual net cash flow is expected to be $40,000. Investment requires no working capital and will have no residual value.

Required: Calculated estimated cash payback period.

Solution:

Cash payback period = Initial investment / Net cash flow

$200,000 / $40,000

5 years

In above example, the annual cash flows are equal ($40,000 per year). If these annual net cash flows are not equal, the cash payback period is determined by adding the annual net cash flows until the cumulative sum equals the amount of the proposed investment. To illustrate, assume that for a proposed investment of $400,000, the annual net cash flows and the cumulative net cash flows over the proposal's 6 year life are as follows:

Year Net Cash Flow Cumulative Net Cash Flow
1 $60,000 $60,000
2 $80,000 $140,000
3 $105,000 $245,000
4 $155,000 $400,000
5 $100,000 $500,000
6 $90,000 590,000

The cumulative net cash flow at the end of fourth year equals the amount of the investment $400,000. Thus, the payback period is 4 years. If the amount of the proposed investment had been $450,000, the cash payback period would occur during the fifth year.

Advantages and Disadvantage of Cash Payback Method:

Advantages:

The cash payback method is widely used to evaluate capital investment proposals in new projects. The sooner the cash is recovered, the sooner it becomes available to invest again in other projects. A short payback period is therefore desirable. When the payback period is short, there is less possibility of losses arising from changes in economic conditions, obsolescence, and other unavoidable risks. The cash payback period is also very important for creditors and financial institutions who depend upon net cash flow for the repayment of debt related to the capital investments. The sooner the cash is recovered, the sooner the debt or other liabilities can be paid. Therefore this method is especially useful for managers because they are concerned with liquidity of the firms and corporations.

Disadvantages:

The cash payback method fails to include the time value of money. This is a major disadvantage of this method. To illustrate, consider two investments, Project X, and Project Y, which both require an investment of $120,000. The cash flows for each investment are as follows:

Year Project X Net Cash Flow Project Y Net Cash Flow
0 ($120,000) ($120,000)
1 60,000 20,000
2 40,000 40,000
3 20,000 60,000
4 40,000 40,000
5 40,000 40,000

The cash payback period for both the projects is three years. Are the two projects equally profitable?

Project X is preferable to Project Y because the higher cash flows occur sooner and are, thus, available to invest and earn a return sooner.

The second disadvantage of cash payback method is that it fails to consider the cash flows occurring after the payback period. To illustrate, consider another two investments, Project A and Project B, which both require an investment of $150,000. The cash flows for each investment are as follows:

Year Project A Net Cash Flow Project B Net Cash Flow
0 ($150,000) ($150,000)
1 50,000 50,000
2 50,000 50,000
3 50,000 50,000
4 0 50,000
5 0 50,000

The cash payback period for both the project is three years. Are they equally profitable? Project B is superior to Project A because of the additional cash flows that occur after the cash payback period. However, these cash flows are ignored under cash payback method, causing both investments to appear equally desirable.

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More study material from this topic:

Methods for the evaluation of capital investment analysis
Average rate of return or accounting rate of return method
Cash payback method
Net present value method
Internal rate of return method
Simple interest
Future value of a single sum
Future value of an annuity
Present value of a single sum
Present value of an annuity
Qualitative consideration in capital investment analysis
Capital investment analysis and unequal proposal lives
Capital rationing decision process
Difference between simple interest and compound interest
Difference between nominal and effective interest rate
Future value of $1 table
Present value of $1 table
Present value of ordinary annuity table
Future value of ordinary annuity table

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Journal, Ledger and Trial Balance
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 

 

 

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