IBBusinessDPBusiness ManagementSLRevision Notes3. Finance & Accounts 3.7 Investment AppraisalSimple Payback Period

Simple Payback Period (DP IB Business Management)

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Lisa Eades

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Introduction to Investment Appraisal

  • Investment appraisal involves comparing the expected future cash flows of an investment with the initial expenditure on that investment 

  • A business may want to analyse 

    • How soon the investment will recoup the initial outlay

    • How profitable the investment will be 

  • Before an investment can be appraised key data will need to be collected, including

    • Sales forecasts

    • Fixed and variable costs data

    • Pricing information

    • Borrowing costs  

  • The collection and analysis of this data is likely to take some time

    • It requires significant experience to interpret the data appropriately before the investment appraisal can take place  

  • Two methods used to appraise the value of an investment, include:

    • The simple payback period

    • The average rate of return (ARR)

Simple Payback Period

  • The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself 

  • Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula


    fraction numerator Initial space Outlay over denominator Net space Cash space Flow space per space Period end fraction space space space space space space space space space space equals space space space space space space space space space space space space space space Years divided by Months

Worked Example

1. Simple Payback Calculation

Gomez Carpets is considering an investment in a new storage facility at a cost of $200,000. It expects additional net cash flow of $30,000 per year as a result of the investment.

Calculate the Payback period for the investment. [3]

Answer:

Step 1 - Substitute the values into the formula

   fraction numerator $ 200 comma 000 over denominator $ 30 comma 000 end fraction space space equals space space space 6.67 space years space space [1 mark]

Step 2 - Convert the outcome to years and months

6 years

0.67 years     =    8.04 months  [1 mark]

Payback period    =    6 years and 8 months  [3 marks for the correct answer]

Worked Example

2. Payback calculation for varying cash flow over time

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for $32,000

The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Year

Net cash Flow ($)

Cumulative Cash Flow ($)

0

(32,000)

(32,000)

1

14,000

(18,000)

2

10,000

(8,000)

3

6,000

(2,000)

4

3,000

1,000

5

2,000

3,000

 Calculate the payback period for the van. [4]
 
Answer:

Step 1 - Identify the final year where the cumulative cash flow is negative

In this case, the cumulative cash flow figure is  -$2,000 at the end of Year 3

This is the remaining amount (outlay) outstanding. [1 mark]
 

Step 2 - Calculate the monthly net cash flow for the next year (year 4)

 $3,000 ÷ 12 (months)       =    $250  [1 mark]
 

Step 3 - Divide the remaining amount outstanding by the monthly net cash flow

 $2000 ÷ $250     =     8 months  [1 mark]
 

Step 4 - Identify the payback period

In this case the Payback period is 3 years and 8 months  [1 mark]

 
Evaluation of the Payback Method

Advantages

Disadvantages

  • It is a simple method to calculate and understand

  • It is particularly useful for businesses where cash flow management is vital

  • Businesses can identify the point at which an investment is paid back and contribute positively to cash flow

  • It is also useful when new technology is introduced regularly

  • Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available

  • It provides no insight into the profitability of investments

  • Payback only considers the total length of time to recover an investment

  • Neither the timing nor the future value of cash inflows is considered

  • This method may encourage a short-termism approach

  • Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

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Lisa Eades

Author: Lisa Eades

Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.