Summary
Highlights
The payback method calculates the time it takes for a project to repay its initial cost. It's straightforward when payback occurs at year-end, but requires a deeper calculation if it falls within a year.
Exam questions typically provide tables with years and net returns. Net return is the difference between predicted revenue and annual costs. Sometimes, you might need to calculate the net return yourself from cash generated and maintenance costs.
To calculate payback for a £10 million initial cost: after year 1, £3 million is recouped, leaving £7 million. After year 2, another £4 million is recouped, leaving £3 million. The project's payback falls within year 3, as it makes £4 million that year, more than the remaining £3 million.
To find the exact payback period when it doesn't align with year-end, take the remaining amount to be paid back (£3 million) and divide it by the net return of the next year (£4 million). This gives 0.75, meaning the payback is 2 years and 0.75 of the third year (2.75 years).
To express the 0.75 year as months, multiply by 12 (0.75 * 12 = 9 months), resulting in 2 years and 9 months. For weeks, multiply by 52 (0.75 * 52 = 39 weeks), making it 2 years and 39 weeks.
The payback method is beneficial for businesses with liquidity problems, new organizations, or smaller firms, as it prioritizes quick return of investment. This frees up cash for other investments and helps generate profit sooner.
A major limitation is that it doesn't consider net returns occurring after the payback period. In the example, the most lucrative fourth year is ignored because the investment has already paid for itself, potentially causing businesses to miss out on profitable long-term projects.