5th Semester : Financial Management Capital Budgeting
Session: 039
Problems on Payback Period method
Illustrations
1. The initial cost of a project is Rs 20000 and the annual cash inflows after tax but before
depreciation are Rs 5000. Find out the payback period of the project.
Solution:
Given,
• Original investment – 20000
• Annual cash inflow - 5000 p.a
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝒑𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
𝟐𝟎𝟎𝟎𝟎
𝒑𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝟓𝟎𝟎𝟎
PBP = 04 years
2. The initial cost of a project is Rs 20000 and the annual cash inflows after tax but before
depreciation are Rs 2000, Rs 3000, Rs 4000, Rs 4000, Rs 5000 and Rs 6000 respectively.
Find out the payback period of the project.
Solution:
Given,
• Original investment – 20000
• cash inflows are uneven, therefore we need to calculate cumulative cash flows
Calculation of cumulative cash inflows
year Cash inflows Cumulative cash inflows
01 2000 2000
02 3000 5000
03 4000 9000
04 4000 13000
05 5000 18000
06 6000 24000
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5th Semester : Financial Management Capital Budgeting
unrecovered cost at the
beginning of the year
PBP = years before full recovery + ( ) × 12 months
cash flows during the year
2000
= 05 yeras + ( ) × 12 months
6000
= 05 years + (0.333) × 12 months
= 05 years + 04 months
PBP = 05 years and 04 months OR 5.33 years
3. A company has an investment opportunity costing Rs. 40000 with the following
expected cash flows after taxes and before depreciation.
• Years 01 to 05 Rs. 7000 each year.
• Years 06 to 09 Rs. 8000 each year.
Determine the payback period. Source: Financial Management/ B. S Raman
Solution:
In the given problem the cash flows are uneven, so we need to calculate cumulative cash
flows to find out the payback period.
Calculation of cumulative cash inflows
year Cash inflows Cumulative cash inflows
01 7000 7000
02 7000 14000
03 7000 21000
04 7000 28000
05 7000 35000
06 8000 43000
07 8000 51000
08 8000 59000
09 8000 67000
unrecovered cost at the
beginning of the year
PBP = years before full recovery + ( )× 12 months
cash flows during the year
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5th Semester : Financial Management Capital Budgeting
5000
= 05 yeras + ( ) × 12 months
8000
= 05 years + (0.625) × 12 months
= 05 years + 7.5 months
PBP = 05 years and 7.5 months OR 5.625 years
4. A project cost Rs. 600000 and yields annually a profit of Rs. 90000 after depreciation at
12.5% p.a. but before tax at 50%. Calculate the payback period.
Source: Financial Management/ SHAHI K GUPTA AND R.K SHARMA
Solution:
In the given problem the original cost of asset is given and the cash flows are after
depreciation and tax, but for the calculation of payback period we need cash flows
before depreciation and after tax.
❖ Calculation of cash inflows before depreciation and after tax
Annual Cash flows after depreciation and after tax 90000
Less : tax @ 50% (90000 X 50% ) 45000
Profits after tax 45000
Add : amount of depreciation
(assumed to be under straight line basis) (600000 X 12.5%) 75000
Profits before depreciation and after tax 120000 p.a
Initial Investment
𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
Annual Cash Inflows
600000
=
120000
PBP = 05 years
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5th Semester : Financial Management Capital Budgeting
5. Calculate the payback periods of the following projects each requiring a cash outlay of
Rs 100000, and suggest the management which of the project is acceptable if the
standard payback period is 05 years.
year Project A Project B Project C
01 30000 30000 10000
02 30000 40000 20000
03 30000 20000 30000
04 30000 10000 40000
05 30000 5000 ---
Source: Financial Management/ SHAHI K GUPTA AND R.K SHARMA
Solution:
In the question information relating to 03 projects is given, we need to find out the best
project for investment out of the three using payback period method.
i Payback period of project-A
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝒑𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
100000
=
30000
PBP = 3.33 years
ii Payback period of project-B
Calculation of cumulative cash inflows
year Cash inflows Cumulative cash inflows
01 30000 30000
02 40000 70000
03 20000 90000
04 10000 100000
05 5000 105000
PBP = 04 YEARS
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5th Semester : Financial Management Capital Budgeting
iii Payback period of project-C
Calculation of cumulative cash inflows
year Cash inflows Cumulative cash inflows
01 10000 10000
02 20000 30000
03 30000 60000
04 40000 100000
05 ---- -----
PBP = 04 YEARS
RECOMMENDATION: project ‘A’ is acceptable as the payback period is lower compared
to other two projects.
NOTE: Though all the projects’ payback period is less than the standard payback period
the management cannot accept all of them. As they need to select only one project it is
advisable to choose project ‘A’ as its payback period is lower compared to other two
projects.
Reference
• Dr. S.N. Maheshwari, Elements Of Financial Management,
• Prasanna Chandra, Financial Management
• V Rajeshkumar and Y Nagaraju, Financial Management
• Lakshmeesha and Akshatha M, Financial Management
• Shahsi k Gupta and R K Sharma, Financial Management Kalyani Publishers
• B S Raman, Financial Management , united publishers
• [Link]
• [Link]
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