Ruth Rachel A. answered • 07/21/23
JD/MBA with Intl Experience in both the Private and Public Sectors
The Payback Period of a project is the amount of time it takes for a project to recover its initial cost.
In order to calculate the Payback Period for a project, you must know 1) the amount of the initial investment in the project (the value of the initial cash outlay), and 2) the net cash flow generated by the project each year:
Payback Period = Initial Investment / Net Annual Cash Flow
In a case where annual cash flows for a project are the same each year, you simply divide the amount of the initial investment by the net annual cash flow.
For example, if the present project had a uniform cash flow of 450 each year, the Payback Period would be 2 years, calculated as follows:
900 / 450 = 2
However, in the present case, annual cash flows are not the same each year. Here, we must calculate the cumulative cash flows for each year of the project:
Y1 420
Y2 420 + 430 = 850
Y3 420 + 430 + 440 = 1,290
Y4 420 + 430 + 440 + 450 = 1,740
Y5 420 + 430 + 440 + 450 + 460 = 2,200
Based upon the cumulative data, we know that the Payback Period for an initial investment of 900 occurs somewhere between the end of Y2 and the end of Y3.
We must now calculate the fractional period between the end of Y2 and the end of Y3 required to meet the amount of the initial investment of 900. This fractional period represents the time it takes to meet an additional cash inflow of 50 (900 - 850 = 50) (amount of the initial investment - the cumulative cash flow at the end of Y2).
Over the 12 months between the end of Y2 and Y3, we know that an additional cash flow of 440 is generated. We must therefore divide 50 by 440 in order to determine the fractional period applicable to these twelve months:
50 / 440 = .1136363636 of a year
Thus, the Payback Period =
2.1136363636 years, which equals 2 years and approximately 1.36 months
