Capital investment appraisal

Payback Period

Definition

Payback period — the period of time it takes for cumulative net cash inflows from a capital project to repay the initial cost of investment.

• The shorter the payback period, the better
• Preferred method for high-technology or fashion projects where obsolescence is a risk

How to Calculate — Cumulative Cash Flow Table

Set up a table of cash flows and running cumulative totals:

Payback = 3 years exactly (cumulative reaches zero at end of Year 3)

Partial-Year Payback

When payback falls within a year:

$$\text{Payback} = \text{Full years} + \frac{\text{Amount still to recover}}{\text{Cash flow in the recovery year}} \times 12 \text{ months}$$

Example: If initial cost were £43 000 (instead of £40 000):

• After Year 3 cumulative = (£3 000) — still £3 000 short
• Year 4 cash flow = £9 000
• Payback = 3 years + (£3 000 ÷ £9 000) × 12 = 3 years 4 months

Choosing Between Two Projects

• Choose the project with the shorter payback period
• If payback periods are equal → choose the project with higher cash flows in the early years (earlier cash flows are more likely to be accurate estimates)