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Calculation of Payback period - warsal - 06-05-2010
To calculate payback period
E.g.
Capital Outlay = 10000
Cash flows = 4000 / year (assuming that cash flows arise at the <b>end of the year</b>)
Then should payback period be 10000/4000 = <u>2.5</u> years
OR
Payback should be <u>3</u> years since the third cash flow would have been received only at the end of year 3?
Thanks
- hmmm - 06-07-2010
i think but not sure it will be 2.5yrs. bcoz we take weighted average. its not mention at any point(mostly in question) when we will receive cash at the end of the period or start like discounted cash flow questions
- warsal - 06-08-2010
It's true what you've just said that payback questions don't mention when cashflows will be received. (In fact they usually assume it will be received over the year with each day contributing an equal amount to any other day.)
Lately I got a question in which it was assumed that cash flows were paid at the end of the year and it got me thinking. I worked it in a way that the result was 3 years (as per this example).
My reasoning behind it was that if cash flows are received at the end of the year than the project could not be considered to have been paid back during the year since no funds would have been received.
- hmmm - 06-09-2010
Warsal
it is disadvantage of payback period method(mentioned in the F9 book of ACCA BPP)
you are right amount should be considered when it received but this is not in Paybak Period
Disadvantage
It ignore the timing of cashflow within payback period
- warsal - 06-10-2010
"The timing of cash flow within payback period" refers that payback doesn't distinguish if £1 is received on the first day or the last day of the "calculated" payback period.
Since £1 on Day 1 or £1 on Day 360 within a 1 year payback period are the same.
The mentioned disadvantage isn't related to calculating payback itself (as my query is) but to the cash flows that occur within the payback period.
- hmmm - 06-11-2010
can you tell me in which book you have read this question?
I also want to solve this question
- warsal - 06-11-2010
No, this question was in an exam paper I had at university.
I checked in some books and it seems that all questions are set with the assumption that cash flows take place all over the year.
The question for my exam was assumed that cash flows arise at the end of the year because one also had to calculate NPV and IRR for the specific projects. Though the assumption with regards to cash flows was related to all the question (ie. NPV, IRR, ARR, Payback period)