Project payback

Question

Project K costs $55,000, its expected cash inflows are $12,000 per year for 11 years, and its WACC is 12%. What is the project's payback? Round your answer to two decimal places

Answer 1

Hi C.C.

The "payback period" is not the same thing as "discounted payback period." First, let's take a look at what you specified, the payback period, which is simply (1) the initial outlay ($55,000) divided by (2) the annual cash flows ($12,000). The answer is 4.58 years.

The main advantage of Payback Period is its simplicity. This works fine if you are funding this project with your own monies or retained earnings and just want a quick snapshot of your payback, with the understanding that it lacks accuracy. However, if your funding is coming from an outside source (family, friends, venture capitalists (VCs), angel investors, etc.), you'll probably need to use a superior methodology that includes a discount rate, if available, or your WACC, which is provided. This would be the Discounted Payback Period.

The simplest and fastest way to calculate this is to use your financial function calculator. Since you're now looking for the discounted payback period, the 11 years is unnecessary and misleading, at least in this example where cash inflows are constant and last beyond what's needed.

PV = 55000; PMT = 12000; % = 12; CPT N, which is 7.05 years.

For longhand purposes ...

Year 1: 12000 x 0.8929 = 10715

Year 2: 12000 x 0.7972 = 9566

Year 3: 12000 x 0.7118 = 8542

Year 4: 12000 x 0.6355 = 7626

Year 5: 12000 x 0.5674 = 6809

Year 6: 12000 x 0.5066 = 6079

Year 7: 12000 x 0.4523 = 5428

Years 1-7 Total = 54765, which is 235 shy of our 55000.

So ....

Year 8: 12000 x 0.4039 = 4847

235/4847 = 0.04848

Answer = 7 + 0.04848 = 7.04848 or 7.05 (rounded to two decimal places)

I hope this helps.

Regards, GE