Pay-back Period Method of Capital Budgeting - Simplest Technique of APC

Yesterday, I saw the paper of MBA and found the question “What is pay-back period method of appraising capital expenditure projects? What are its merits and demerits? This question is taken from the methods of capital budgeting one of chapter of Management Accounting . Pay-back period method is the traditional method of capital budgeting.

Meaning of Pay-back period

Pay-back period is the period in which investors obtains his amount of investment in fixed asset. Suppose, you have purchased the fixed asset of Rs. 100000 and after operating this fixed assets in business and earned Rs. 100000 in three years. Therefore 3 years are the pay-back period of investment in fixed asset. This period can also estimate on the basis of previous experience with same project.

Pay-back Period Method

After knowing what pay-back period is, it is easy to understand pay-back period method. It is the method in which we calculate pay-back period of different projects in which investor can invest his money. After this, investor compares length of period. Investor will accept only that project for the purpose of investment whose pay-back period is least out of different alternatives of projects. Other projects will be rejected.
If there is only one project in which investor wants to invest. At that juncture, investor will accept the project if its pay-back period will be less than standard pay-back period which is made by the management of investor or company.
Steps to Calculate Pay-back period

Ist Step

Calculate Net profit before depreciation and after tax. It is annual cash flows.

2nd Step

Calculate Pay-back period

(A) When annual profits on investment before depreciation and after tax are equal

(B) If Annual cash inflow is not equal, then add these till it equal to cost of project. After this, count this period.

Example

A project costs Rs. 100000 and yields annual cash inflow of Rs. 20000 for eight years. Calculate its pay back period.
In this case we will choose (A) from second step because annual profit on the project is equal

Practical Use of this method in appraising capital expenditure projects
Suppose, an investor has looked a machine in two company which can do same work. Its cost is also same of Rs. 20000. Now investor has to decide which machine, he has to purchase on the basis of given A machine and B machine.

The following information is given by machine providers. Net profit before depreciation and after tax from machines

Pay-back period of machine A is 5 years

Because if we add the profit from machine a , it will be equal to Rs. 20000 which is cost of machine

First year profit 1000 + second year profit 2000 + third years profit 4000 + fourth year profit 5000 + fifth year profit 8000 = Rs. 20000

In machine B, the payback period is 4 year because cost of machine can obtain from its profit with in 4 years [* for calculating payback period part (B) of Step 2 will apply]
Hence, investor should purchase B machine because according to pay-back period, it will return the expenditure of machine purchasing before Machine A.
Special Tips for Calculating Pay-back period ·

If in practical question , rate of depreciation and tax are given , then annual profit will be adjusted from them

Annual profit or annual cash flow

= Annual net profit + Depreciation – Tax

· If adding the total of annual profits are not equal to cost of project , then following formula can be used

Merits of Pay- back Period Method

1. This method is easy to understand.
2. A small investor can calculate this period himself and save money which he has to give to financial analyst.
3. In this method, investor can save from obsolescence . Obsolescence is loss due to changing in technology. Because, Investor will prefer that fixed asset which return his investment cost within shortest time.

Demerits of Pay-back Period Method

1. In the beginning of any fixed asset, it may possible that fixed asset will not give higher profit but after some times, it will start higher profit. So, this method is not proper evaluation of profitability from different assets.

2. This method ignores the time value of money. It means the value of One rupees which we have earned today is more than which we will earn after one year. Suppose two projects have same payback period which is 5 year but first project is giving profit by increasing its amount Rs. 1000 , 2000 , 3000 , 4000 , 5000 and other project is giving profit by decreasing its amount Rs. 5000 , 4000 , 3000 , 2000 , 1000 . According to payback period, both project are good but in reality B project is better than A because, it is giving higher profit in first and second year.

3. Cost of capital is also ignoring in this method. Suppose, if we purchased asset on loan, then we also check what is rate of loan and compare it with profitability of asset.