The payback period is the time a project’s cash flows will take to accumulate the initial investment. This is one of the capital budgeting techniques to evaluate that a project is worth for investment or not. If the payback period of a project is within the acceptance criteria (allowable payback period) then the project is accepted.
A project that has an initial investment of $500,000 and it generates an annual cash flow of $200,000 for 5 years. Company ABC has a policy of accepting capital investment projects that payback the initial investment within 3 years.
|
Year |
Cash Flows |
Amount Returned |
Amount Left |
Payback period |
|
0 |
-500000 |
0 |
500000 |
0 |
|
1 |
200000 |
200000 |
300000 |
1 |
|
2 |
200000 |
200000 |
100000 |
1 |
|
3 |
200000 |
200000 |
0 |
0.5 |
|
4 |
200000 |
|
|
|
|
5 |
200000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2.5 |
Based on the cash flows the investment will be fully recovered in 2.5 years, so Company ABC will accept this project.
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