The Cash Payback Method of Cost Estimation - dummies

The Cash Payback Method of Cost Estimation

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Companies invest in capital projects — buying big things like factories, equipment, and vehicles — to earn profits and a return on their investment. Therefore, managers need tools and techniques to evaluate different capital projects and decide which ones to invest in and which ones to avoid.

One such tool is the cash payback method, which estimates how long a project will take to cover its original investment. You can calculate the cash payback method whether you have equal payments each period or unequal payments. The main benefit of the cash payback method is that you can calculate it on the fly to quickly screen out investments.

Although it’s quick and easy, the cash payback method doesn’t account for the full profitability of the project; it ignores any payback earned after the cash payback period ends. Furthermore, because this approach neglects the time value of money, managers should use a more sophisticated model, such as the net present value method, before investing company funds into any project.

Using the cash payback method with equal annual net cash flows

The cash payback method uses the following formula to compute how long a given project will take to pay for itself. When computing cash payback period, annual net cash flow should include all revenues arising from the new project less expected incremental costs.

Note that net means “to offset,” and net cash flows means that you’re subtracting cash outflows from cash inflows (or vice versa). Therefore, to compute annual net cash flow, you estimate any potential revenues and then add in savings in materials, labor, and overhead associated with the new project. Offset any additional costs associated with the new project against these cash inflows.

The following formula works in a situation where each year’s net cash flows from the investment are expected to be equal:

Cash payback period = Cost of investment / Annual net cash flow

Simply divide the cost of the investment — how much you initially paid for the investment — by the estimated net cash flow the investment generates each year. The higher the cash payback period, the longer the time needed to recover your investment.

For example, suppose you need to decide whether to buy a new computer costing $500; you expect the computer to increase your net cash flow by $300 per year. Plug the numbers into the formula:

Cash payback period = Cost of investment / Annual net cash flow = $500 / $300/year = 1.67 years or 1 year and 8 months

Here you can see that the computer would take one year and eight months to pay for itself.

When making investment decisions, one consideration is to compare the cash payback period of one project with that of another and select projects that offer the quickest cash payback period. Suppose a less-expensive computer has a cash payback period of only nine months; compared to one year and eight months, the nine-month cash payback period suggests that the less-expensive computer is probably a better investment for your company.

Of course you need to consider several factors when choosing which computer to buy. Keep in mind that cash payback period doesn’t account for the time value of money and several other factors that may impact your decision.

Applying the cash payback method when annual net cash flows change each year

When computing cash payback period, remember to include all revenues arising from the new project less expected incremental costs in each year’s net cash flows. When preparing this computation, the net cash flow will probably vary each year. If so, just project the net cash flows that you expect to realize or incur each year.

For example, suppose that your new $500 computer is expected to yield different net cash flows each year.

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The computer will be fully paid off in 2016, when cumulative net cash flows of $750 exceed the initial investment of $500. To be more specific, the $500 cost will be fully recovered sometime during 2016. You start the year 2016 with $350 in cash inflows. A total of $400 additional dollars are received during 2016.

Depending on when the dollars come in, you may receive the last $150 in May or June of the year. That additional $150 means that you have recovered all your costs.

When computing net cash flows, use cash flow rather than accrual income amounts. For example, use projected cash receipts from customers rather than sales.