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Learning Objectives of this
article:
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Define and explain cash payback
method of capital investment evaluation.
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How is it calculated?
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What are the advantages and
disadvantages of this method?
Contents:
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.
Payback period is equal to the time
required to recover the initial outlay for the plant
asset. It is calculated by the following formula:
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Cash payback period =
Initial investment / Net cash flow |
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:
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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 |
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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:
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 |
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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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