In this blog I will try to explain one of the simplest calculation techniques that can help managers select particular investment.
As managers we may be involved in capital investment decisions. For some managers projects become bigger, some millions of pounds. We may need to decide which one to go for and how it should be financed.
We need to have some knowledge of those methods to know the basics to be in a better position to make those managerial decisions.
There is a difference between 'capital' expenditure and 'revenue' expenditure. 'Capital' expenditure provides benefits for more then a year. Revenue does so for only one year and it has to be renewed for the benefit to continue.
Capital expenditure is generated to help the entity to achieve its long term objectives, large sums of money being spent on major projects and may benefit staff long term.
Payback
The payback method it allows to calculate how long it will take for a project to pay for itself. The recovery is generally measured 'net cash flow' which is the difference received between cash received and cash paid in a defined period of time. For this method we need:
* The total cost of the investment;
* Amount of cash instalment payed on that investment;
* Accounting period in which the instalment will be paid;
* Cash receipts connected with the project;
* Accounting periods in which they fall.
Payback measures the rate of recovery in terms of net cash flow and non-cash items ( depreciation, fixed assets) are not taken into consideration.
Example
Source: Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
This method is a fairly straightforward technique but it has its disadvantages. One is that an estimate has to be made in the amount of timing and cash instalments and it is difficult to calculate the cashflow in the future periods. This method, however, help managers to compare projects and think it terms on how long it will take before it recovers its original cost.
The use
The payback period is the amount of time that would take to recover projects initial cost. It is closely related to the break-even point of the investment. It is expressed in years and the shorter the payback period, the more attractive the investment would be. It can be used by businesses to calculate the rate of return of any new asset or technology upgrade. We simply divide the initial cash outlay of the project by the amount of net cash inflow that the project generates each year. We can assume that the cash inflow is the same in each year.
Payback period = Initial investment / Annual Payback
For example, we can invest £200,000 in new manufacturing equipment that results in positive cash flow of £50,000 per year. Then the Payback period would equal £200,000 divided by £50,000 which is four years. We can compare all investments that we are considering and opt for the shortest one.
This calculation acts as a simple risk analysis and gives a quick overview on how quickly we can recover out initial investment. We can conduct a side-by-side analysis of two competitive projects and the shorter period may be the better option.
One disadvantage of this method is that it does not show specific profitability. One project may pay back faster, but in the long run may not be as profitable as another project. This method also does not take the time value of money into account.
Using this method may be, however, a good staring point to calculate the time for investment when it reaches its breakeven point.
It is a method widely used by investors, financial professionals and corporations to calculate investment returns. It may be useful when an investor may need to take a snap decision about an investment.
For example, if solar panels cost £5,000 to install and the savings are £100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as 9- 10 years for residential homeowners in the UK to break even on their investment.
This method can be used for homeowners and businesses to calculate the return on energy efficient technologies or information technologies.
Unfortunately, this method does not include the opportunity costs and ignores the investments overall profitability.
We know that the best payback period is the shortest one possible, but not all projects and investments have the same time horizon. The payback period is not the same as break-even point. The breakeven point is the price or value that the investment on project must raise to cover the initial cost. The payback refers to how long it takes to reach the breakeven.
The payback calculation is a simple one, but it does not account for the time value of money, the effect of inflation or the complexity of the investment and effect on the cashflow in time.
The appropriate time frame for an investment will vary depending on the time of project and the expectations of those undertaking it. They may take it into consideration when deciding on whether to invest or not.
Bibliography
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
GoCardless, 2022, "How to calculate the payback period", accessed from https://gocardless.com/guides/posts/how-to-calculate-payback-period/#:~:text=To%20determine%20how%20to%20calculate,the%20project%20generates%20each%20year. accessed on 23/04/2023
Julia Kagan, 2023, " Payback period explained, with the formula and how to calculate it", Investopedia, accessed from https://www.investopedia.com/terms/p/paybackperiod.asp , accessed on 23/04/2023
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