Pay Back Method
Computation The pay back method (PB) is the second traditional method of capital budgeting. It is the simplest and, perhaps, the most widely employed, quantitative method for appraising capital expenditure eds ions. This method answers the question: How many years will it take for the cash benefits to pay the original cost of an investment, normally disregarding salvage “”ilue? ‘Cash
hen efits here represent CFAT ignoring interest payment. Thus, the pay back method (PB) measures the number of years required for the CFAT to pay hack the original outlay required in an investment proposal.
There tire two ways of calculating the I’ll period. Tile first method can be applied when the cash now stream is in the nature of annuity for each year of the project’s life, that is, CFAT are uniform. In M K h a situation the initial cost of the investment is divided by’the cons tarn annual cash flow
For example, an investment of Rs 40,000 in a machine is expect to produce CFAT-of Rs 8,000 for 10 yea rs,
The initial investment of Rs ‘;6.12-; on machine A will be recovered between years 3 and 4. The pay hack period would he a fraction more than 3 years. The sum of Its 8,000 is recovered ‘by the end of the third year. The balance Rs 8. I 25 IS needed to be recovered in the fourth year. In the fount year (FAT is R.~20.000. The pay back fretting is. therefore, 0.406 (Rs R,I2i ‘Rs 20.000 l The pay hack period for machine A is 3.406 years. Similarly. for machine II the pay hack period . would he 2 years and a fraction of a year. As Rs 2,000 is recovered by the end of the second year, the balance of Rs 1-1,125 needs to be recovered in the third year. In the third year CFAT is Rs 18,000. The pay back fraction is 0.78″) (Rs 14.i25, Rs 18.000 the period for machine II is 2.785 years.