Payback Period = First cost / Net Income per
unit time
Compare results to a maximum
allowable time (Set by management).
Compare two
or more alternates together.
Example : A company is to buy $15,000 of
equipment, with the cost of maintenance being $1000 per
year. Income is $4000 the first year and $1000 /yr
after. Maximum payback period allowed is 4 years. Should the company buy
the
equipment?
Year Income Maintenance Net Income Cumulative NI
1 4000
1000
3000 3000
2 5000 1000 4000
7000
3
6000 1000
5000
12000
4
7000 1000
6000 18000
5
8000 1000 7000
6
9000 1000
8000
The Payback is between
years 3 and 4, since the cumulative net income reaches
$15,000 in that period..
By Interpolation :
Payback Period =
3 + 15000-12000 = 3.5 years < 4 years minimum.
Hence OK to
buy.
18000-12000
Note that the
time value of money was not accounted for with interest.
Example: Let's try the previous example,
but now accounting for future values of each year's net income @ i =
6%.
Year
Net
Income
X(P/F,6,N)
Cumulative
1
3000
0.9434 =
2830
$2830
2
4000 0.8900
=
3560
$6390
3
5000 0.8396
=
4198 $10588
4 6000 0.7921=
4753 $15341
5 7000 0.7473
=
5231
Payback Period = 3 +
15000-10588
= 3.92 yrs = > close to cut-off 4
years
15341-10588
Example: Now let's compare two separate alternatives to one another.
Machine 1 Machine 2
1st cost $10000 $14000
Year NCF* Total NCF NCF* Total NCF
1
$4000
4000
$2000
2000
2
$4000
8000 $3000
5000
3 $2000
10000 $4000 9000
4
$1000 11000 $5000
14000
5
$1000 12000 $6000
20000
6
$1000 13000 $7000
27000
7
$1000 14000 $8000
35000
*
Equivalence to present is already
accounted.
Machine 1 --- Payback 3
years
Machine 2 ---
Payback 4
years
The method says to choose Machine 1. Is this correct? What about the NCF past the Payback Period? Shouldn't it be accounted for?
Method Review
There are good and bad points to the payback period method.
Plusses: Easy to
use.
Reasonable
to
understand (Especially to the
layman).
Quick to analyze.
Minuses: Tends to ignore time value of
money.
Ignores
long term benefits of higher NCF past the Payback
period.
In the last example- Machine 2 NCF increases after 4 years and Machine 1 NCF decreases after 2 years. Which machine would you rather have for the long term?
Company payback criteria is
arbitrary.
2yrs? 3 yrs?
What is right?
When using this method: Always use present values
of NCF.
Use only on
short term
projects.
Don't use as the sole analysis
tool.
| |
| Added to the Web: May
20, 2002. Last updated: April 26, 2002. Web page design by Dan Solarek. |
 http://cset.sp.utoledo.edu/engt3600/ |