Payback period is an investment decision technique that is used a lot in some industries. Now the utilities industry for example. Payback period as mentioned, identifies the number of years that it takes to recoup your initial capital outlay. And in decision rule would be chose the investment that has the shorter payback period. Some organizations in some industries have very set rules with respect to the payback period, so they may say you are not allowed to undertake a capital project unless you have a payback period of two years or less. Or we will not approve any capital expenditure with a payback period longer than 24 months. And so those rules are usually very, very steadfast and not very flexible. Are they good rules or bad rules? Let's look at how you calculate the payback period. Here, we have an example where we have an uneven cash flow or unequal cash flows. So we're going to spend $10,000 and we're going to have a positive cash flow of $2,000 in the first year, $2,000 in the second year $2,500 in the third year, $3,000 in year four and an additional $3,000 in year five. Well, if we have an even cash flow, we just take our initial investment and divide it by our cash flow and this will give us the number of years it takes to pay back. So, if we have a $10,000 initial outlay and a $2,000 cash flow, we would have a payback period of 5 years. If we had a $10,000 outlay and a cash flow of $2,700, we would have a payback period of 3.7 years. That's terrific, but with an unequal flows you have to do a little bit more mathematical wrangling. In this case, I'll show you that with this cash flow of $2,000, $2,000, $25,000, $3,000 and $3,000, what you have to do is you have to subtract your cash flow from your initial capital. And then identify the remainder, what you have left to pay back relative to your next cash flow. And if your remainder is larger, then you essentially add a 1 to the number of periods and then you continue. So in this example here, I've got $10,000 and my initial cash flow is $2,000. So, $10,000 is greater than $2,000, I add a one, I subtract $2,000 and I had $8,000. Year two, $8,000 is greater than $2,000 so I add a one, I subtract my $2,000 and now I have $6,000. $6,000 is greater than $2,500 I add a one and subtract the $2,500 and now I've got $3,500. $3500 relative to $3000. $3,500 is greater than three. So I add a 1, I subtract my $3,000 and now I have $500. So $500 is less than the last payment of $3,000. So I divide five by 3,000 and I get 0.17. So now I add up all my ones. One, two, three, four plus my 0.17 and so my payback period under this cash flow would be 4.17 years. Now the pros and cons are that the payback period does not ordinarily differentiate between future cash flows that are larger or future cash flows that are smaller. For example, let's look at these two projects, project 1, I have an initial cash outlay of $10,000 and paybacks of $2,000, $2,000 $2,500, $3,000 and $3,000. Project 2 with an initial cash outlay of $10,000 gives me a cash flow of $2,000, $3,000, $2,500, $2,000 and $3,000. Each one of these has a payback period of 4.17 years. So, on their phase they would look equivalent. However, if you discount them, you'll notice that Project 2 brings in more cash quicker. So the discounted cash flow of project two will have a smaller payback period that a discounted cash flow of project one. So even though on their face they look equivalent, if you consider discounting the future cash flows, project two is much more attractive. The advantages and disadvantages of the payback period are that the payback period is really easy to understand and calculate. It's a number of years, two years, three years. It can be communicated and understood. This is why lots of industries rely on this decision technique, okay. It's a reasonable approach. It is a number that is easily digested. The disadvantage is that ordinarily, it ignores the time value of the money that you're going to get in the future. So there's no discounting involved, which means that you may forgo a project that is very profitable but you're not going to see the money for three, four, five years. And it would be heavily influenced towards taking up projects that see lots of cash upfront and very little after that. So what it does is it forces your company to undertake projects where the cash flow is much stronger, much faster. Even though that another project may have a larger stream of cash involved and it may have a higher net present value, the payback period would force you into choosing projects that have strong early cash flows, rather than strong late cash flows.
