The pay back period is the traditional method of evaluating investment proposals under capital budgeting. It is the simplest and perhaps the most widely employed quantitative method for appraising capital expenditure decisions. It is also called payout or pay off period. It calculates the period of return back of investment. Pay back period is the time period required to recover the investment made in a project. Thus, PBP measures the number of years to pay back the original outlay from cash inflows generated by an investment proposal.
Calculation Of Pay Back Period (PBP)
There are two ways of calculating PBP:
1. Even Cash Flow
Even cash flow is also known as equal amount of cash flow during the life period of project. The following formula is use to calculate PBP if cash flow is equal:
PBP = Investment/Constant annual cash flow after tax(CFAT)
2. Uneven Cash Flow
If the amount of cash flow are different, it is known as uneven cash flow. In such a situation, PBP is calculated by process of cumulating cash flow still the time when cumulative cash flow become equal to the original investment outlay. The following formula is used to calculate PBP when cash flow is not equal:
PBP = Minimum year + Amount to be recovered investment/CFAT of next year.
Decision Rules Of Pay Back Period (PBP)
A. If projects are independent:
Accept the project whose pay back period is less than the life or standard pay back period.
Reject the project whose pay back period is more than the life or standard pay back period.
B. If projects are mutually exclusive:
Accept the project with lowest pay back period.
Advantages Of Pay Back Period (PBP)
1. Pay back period is simple and easy to understand and compute.
2. Pay back period is universally used and easy to understand.
3. Pay back period gives more importance on liquidity for making decision about the investment proposals.
4. Pay back period deals with risk. The project with a shortest PBP has less risk than with the project with longest PBP.
5. The short term approach of pay back period is an added advantage of calculation of capital expenditure.
Disadvantages Of Pay Back Period (PBP)
1. In the calculation of pay back period, time value of money is not recognized.
2. Pay back period gives high emphasis on liquidity and ignores profitability.
3. Only cash flow before the pay back period is considered. Cash flow occurred after the PBP is not considered.