Simple Payback Period (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
Introduction to Investment Appraisal
Investment appraisal involves comparing the expected future cash flows of an investment with the initial expenditure on that investment
A business may want to analyse
How soon the investment will recoup the initial outlay
How profitable the investment will be
Before an investment can be appraised key data will need to be collected, including
Sales forecasts
Fixed and variable costs data
Pricing information
Borrowing costs
The collection and analysis of this data is likely to take some time
It requires significant experience to interpret the data appropriately before the investment appraisal can take place
Two methods used to appraise the value of an investment, include:
The simple payback period
The average rate of return (ARR)
Simple Payback Period
The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself
Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula
Worked Example
1. Simple Payback Calculation
Gomez Carpets is considering an investment in a new storage facility at a cost of $200,000. It expects additional net cash flow of $30,000 per year as a result of the investment.
Calculate the Payback period for the investment. [3]
Answer:
Step 1 - Substitute the values into the formula
[1 mark]
Step 2 - Convert the outcome to years and months
6 years
0.67 years = 8.04 months [1 mark]
Payback period = 6 years and 8 months [3 marks for the correct answer]
Worked Example
2. Payback calculation for varying cash flow over time
Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for $32,000
The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.
Year | Net cash Flow ($) | Cumulative Cash Flow ($) |
---|---|---|
0 | (32,000) | (32,000) |
1 | 14,000 | (18,000) |
2 | 10,000 | (8,000) |
3 | 6,000 | (2,000) |
4 | 3,000 | 1,000 |
5 | 2,000 | 3,000 |
Calculate the payback period for the van. [4]
Answer:
Step 1 - Identify the final year where the cumulative cash flow is negative
In this case, the cumulative cash flow figure is -$2,000 at the end of Year 3
This is the remaining amount (outlay) outstanding. [1 mark]
Step 2 - Calculate the monthly net cash flow for the next year (year 4)
$3,000 ÷ 12 (months) = $250 [1 mark]
Step 3 - Divide the remaining amount outstanding by the monthly net cash flow
$2000 ÷ $250 = 8 months [1 mark]
Step 4 - Identify the payback period
In this case the Payback period is 3 years and 8 months [1 mark]
Evaluation of the Payback Method
Advantages | Disadvantages |
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