# How long does it take to get the initial cost back in

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How long does it take to get the initial cost back in a nominal sense?ComputationEstimate the cash flowsSubtract the future cash flows from the initial cost until the initial investment has been recoveredDecision Rule – Accept if the payback period is less than some preset limit
Project Example InformationYou are looking at a new project and you have estimated the following cash flows:Year 0:CF = -165,000Year 1:CF = 63,120; NI = 13,620Year 2:CF = 70,800; NI = 3,300Year 3:CF = 91,080; NI = 29,100Average Book Value = 72,000Your required return for assets of this risk is 12%.
Computing Payback For The ProjectAssume we will accept the project if it pays back within two years.Year 1: 165,000 – 63,120 = 101,880 still to recoverYear 2: 101,880 – 70,800 = 31,080 still to recoverYear 3: 31,080 – 91,080 = -60,000 project pays back in year 3If the preset limit is 3 years, do we accept or reject the project?
Decision Criteria Test - PaybackDoes the payback rule account for the time value of money?Does the payback rule account for the risk of the cash flows?Does the payback rule provide an indication about the increase in value?Should we consider the payback rule for our primary decision criteria?
Advantages and Disadvantages of PaybackAdvantagesEasy to understandAdjusts for uncertainty of later cash flowsBiased towards liquidityDisadvantagesIgnores the time value of moneyRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff dateBiased against long-term projects, such as research and development, and new projects
Discounted Payback PeriodCompute the present value of each cash flow and then determine how long it takes to payback on a discounted basisCompare to a specified required payback periodDecision Rule - Accept the project if it pays back on a discounted basis within the specified time
Computing Discounted Payback for the ProjectAssume we will accept the project if it pays back on a discounted basis in 2 years.Compute the PV for each cash flow and determine the payback period using discounted cash flowsYear 1: 165,000 – 63,120/1.121= 108,643Year 2: 108,643 – 70,800/1.122= 52,202Year 3: 52,202 – 91,080/1.123= -12,627 project pays back in year 3Do we accept or reject the project?
Advantages and Disadvantages of Discounted PaybackAdvantagesIncludes time value of moneyEasy to understandDoes not accept negative estimated NPV investmentsBiased towards liquidityDisadvantagesMay reject positive NPV investmentsRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff dateBiased against long-term projects, such as R&D, and new projects
Internal Rate of ReturnThe most important alternative to NPVOften used in practice, intuitively appealingBased entirely on the estimated cash flows; independent of interest rates found elsewhereDefinition: IRR is the return that makes the NPV = 0Decision Rule: Accept the project if the IRR is greater than the required return