Our taxi driver is back again looking for more information on his investment. Last time we looked at the ‘net present value’ technique for investment appraisal; today we cover the ‘payback period’ technique.
The Payback Period
The payback period is concerned with only one thing: how long does it take to payback the ‘original outlay’, or the original investment. Unlike the net present value, the payback period calculates the final figure in time, not money. So for our taxi driver, we’re concerned with seeing how long it takes to payback the hefty £31,000 initial outlay of the taxi.
Again, we’ll apply the payback period over a five year period. At the end of each year, we get a ‘cumulative cash flow’. To get this figure, we need to add and subtract various cash flows – with the initial outlay already putting our taxi driver at -£31,000.
Last time we assumed our taxi driver’s salary would be £22,500. To obtain our cumulative cash flow for year one, we must combine the initial outlay of £31,000 with our positive cash flow of £22,500.
-£31,000 + £22,500 = -£8,500
Our taxi driver ends the first year £8,500 down so it will take longer than a year to payback that initial outlay. Let’s factor in year two and another £22,500:
-£31,000 + £22,500 + £22,500 = +£14,000
By the end of the second year, our taxi driver will have paid back the initial outlay and made a £14,000 profit. The ‘cumulative cash flow’ is, therefore, £14,000 at the end of year two.
Job done, right? Not quite. In an assessment, you’ll be required to find out a more accurate figure than ‘between one and two years’. Depending on your preference, you can find out the accurate number of months it took to payback the initial outlay in two ways:
Take the cumulative cash flow from the end of year one, -£8,500 for our taxi driver, divide by the full year positive cash flow, £22,500, and times by 12:
£8,500 / £22,5000 X 12 = 4.533 months
You could find the monthly positive cash flow and see how many times that goes into the end of year one cumulative cash flow.
£22,500 / 12 = £1,875
£8,500 / £1,875 = 4.533 months
You may be required to round this number up to whole months. In this case, it would mean that the initial outlay of £31,000 for the taxi took approximately one year and five months to payback. A company would then look at this figure and decide if that matches their business objective. If they had a five year period in mind, this investment would certainly look worthwhile.