225 capital expenditure pays back itself this method

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225 capital expenditure pays back itself. This method is based on the principle that every capital expenditure pays itself back over a number of years. It means that it generates income within a certain period. When the total earnings (or net cash- inflow] from investment equals the total outlay, that period is the payback period of the capital investment. An investment project is adopted so long as it pays for itself within a specified period of time says 5 years or less. This standard of recoupment period is settled by the management taking into account a number of considerations. While there is a comparison between two or more projects, the lesser the number of payback years, the project will be acceptable. The formula for the payback period calculation is simple when the cash inflow is even throughout life of the project/ Machine/ Capital investment. First of all, net-cash-inflow (Profit after Tax Before Depreciation) is determined. Then we divide the initial cost (or any value we wish to recover) by the annual cash-inflows and the resulting quotient is the payback period. As per formula: If the annual cash-inflows are uneven, then the calculation of payback period takes a cumulative form. We accumulate the annual cash-inflows till the recovery of investment and as soon as this amount is recovered, it is the expected number of payback period years. An asset or capital expenditure outlay that pays back itself early comparatively is to be preferred. Payback Method Merits The payback period method for choosing among alternative projects is very popular among corporate managers and according to Quirin even among Soviet planners who call it as the recoupment period method. In U.S.A and U.K. this method is widely accepted to discuss the profitability of foreign investment. Following are some of the advantages of pay back method: 1. It is easy to understand, compute and communicate to others. Its quick computation makes it a favorite among executive who prefer snap answers. 2. It gives importance to the speedy recovery of investment in capital assets. So it is useful technique in industries where technical developments are in full swing necessitating the replacements at an early date. 3. It is an adequate measure for firms with very profitable internal investment opportunities, whose sources of funds are limited by internal low availability and external high costs. 4. It is useful for approximating the value of risky investments whose rate of capital wastage (economic depreciation and obsolescence rate) is hard to predict. Since the payback period method weights only return heavily and ignores distant returns it contains a built-in hedge against the possibility of limited economic life.
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226 5. When the payback period is set at a large “number of years and incomes streams are uniform each year, the payback criterion is a good approximation to the reciprocal of the internal rate of discount.
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