- Describe the pay-back method
When we talk about the payback method, it is important to have a couple of pieces of information. First, we need the initial purchase price. We will also need to know what our net cash flow per year will be with this purchase. With this information, we can figure out how many years it will take to get our initial investment back.
This method, along with the net present value method and the internal rate of return method, all use cash flows to determine decisions. Typical cash outflows include the initial investment in the equipment or project, including any installation costs or additional capital needed. Cash inflows may include the salvage value of the equipment, if any, increase in revenues and decreases in expenditures.
Let’s look at an example of the payback method.
We purchase a $50,000 piece of machinery to make our widgets today. We will get $10,000 in net cash flow per year from this piece of machinery. What is our payback period?
5 years = $50,000/$10,000
So if we make this purchase, it will take us five years to get back our initial investment. Let’s look at a couple of other options:
- Machine A: Purchase price $25,000. Net annual cash flow $5,000
- Machine B: Purchase price $36,000. Net annual cash flow $9,000
Machine A would pay back the initial investment in 5 years ($25,000/$5,000 per year) while machine B would pay back the initial investment in 4 years ($36,000/ $9,000 per year). So if we are just looking at the payback period, we would pick machine B, even though it costs more than machine A! The initial cash outlay is higher, but the money would be brought back into the company quicker. There may be other factors in play, but this method would encourage purchasing the more costly machine.