Capital Budgeting Criteria: Payback
Payback analysis in 5 easy steps
Step 1: Find the outlay, which is the amount of cash that must
be recovered (equals -C
0
in FNAN 301/303)
Step 2: compute expected CF needed after 1 year to reach
payback (equals outlay minus C
1
)
•
If zero, then payback period is exactly 1 year
Go to step 5 (decide whether to invest or not)
•
If negative, then more CF than needed for payback is expected in
year 1 and payback period is between 0 and 1 year
Go to step 4 (find the payback period when it is “mid-year”)
•
If positive, then insufficient expected CF is expected by the end of
year 1 for payback, so payback period is greater than 1 year
Go to step 3
Step 3: repeat step 2 for each year (starting with year 2) to
reach payback until either payback is reached or all years in
the project have been analyzed

dgeting criteria - 38
Capital Budgeting Criteria: Payback
Payback analysis in 5 easy steps
Step 4: find the payback period when it is “mid-year”
•
The project is expected to reach payback between t and t+1
years if
Not enough cumulative CF for payback is expected at time t
More cumulative CF than needed for payback is expected at yr t+1
•
Assume that the expected cash flow produced by a project
for a given year is produced at a uniform rate throughout
the year
•
The portion of year t+1 that it will take to produce the cash
needed for payback is
Expected CF needed for payback after t yrs / expected CF in yr t+1
•
The payback period is t + (the portion of year t+1 that it
will take to produce the cash needed for payback)

dgeting criteria - 39
Capital Budgeting Criteria: Payback
Payback analysis in 5 easy steps
Step 5: decide whether to invest or not
•
Accept project if the payback period is less than or equal to
the limit set by the firm
•
Reject project if the payback period is greater than the limit
set by the firm

dgeting criteria - 40
Capital Budgeting Criteria:
Payback – Example
Year
Expected cash
flow (CF)
during year
Present value of
expected CF
during year
Project expected CF needed after end
of year = project expected CF needed
after end of previous year minus
expected CF during year
0
-1,650
Not relevant for
payback period
(but will be for
discounted
payback
period)
1
650
2
700
3
900
Tables are very useful when computing payback
(and discounted payback)
Project Z

dgeting criteria - 41
Capital Budgeting Criteria:
Payback – Example
Year
Expected cash
flow (CF)
during year
Present value of
expected CF
during year
Project expected CF needed after end
of year = project expected CF needed
after end of previous year minus
expected CF during year
0
-1,650
Not relevant for
payback period
1,650
1
650
1,650 – 650 = 1,000
2
700
3
900
Project Z