How to Calculate Payback Period-Capital Budgeting Techniques
Payback period is calculated by capital invested in the project by the net annual cash flow. Average of net annual cash flows may be used if net annual cash flows are not expected to be the same.
Payback Period= Initial Investment/Average Annual Cash Flows
For example a Project A yields following cash flows over its 5 years life.
| Year | Cash Flows |
| 0 | $(10,000) |
| 1 | 2,000 |
| 2 | 4,000 |
| 3 | 3,000 |
| 4 | 2,000 |
| 5 | 3,000 |
For computing Payback Period of Project A, first we need to calculate Net Cash Flow (NCF) of the project in each year.
| Year | Cash Flows | Net Cash Flow |
| 0 | $(10,000) | $(10,000) |
| 1 | 2,000 | (8,000) |
| 2 | 4,000 | (4,000) |
| 3 | 3,000 | (1,000) |
| 4 | 2,000 | 1,000 |
| 5 | 3,000 | 4,000 |
Now, you can see after 3 years Net Cash Flow of the project is negative (-10,000+2000+4000+3000=-1000) while after four years Net Cash Flow is positive (-10,000+2000+4000+3000+2000=1000). Thus Pay Back period of this project come about in the course of fourth year. Suppose these cash flows occur frequently all through the year, the payback period can be calculated by using this equation;
Payback period= [last year with a -ive NFC] + [Absolute value of NFC in that year/Total CF in the next year]
Payback Period= 3 + (1000/2000)
Payback period=3.5 Years
Thus the project will recover its initial investment in 3.5 Years.
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