Corporate financeLesson 1 of 3 in the course How Companies Think about Investing

Payback Period: Calculation, Uses, and Limitations

5 flashcards · 5 quiz questions · 5 match pairs · 4 fill-in sentences · English

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Summary

The payback period is a simple way to estimate how long an investment takes to recover its initial cost through cash inflows. In this lesson, we will define the measure and calculate it using annual cash-flow information.

The payback period is the length of time required for a project’s accumulated cash inflows to equal its initial investment. In other words, it measures how long it takes the project to recover the money originally invested.

All flashcards

What is the payback period?
The time required for a project’s accumulated cash inflows to recover its initial investment.
What should be tracked to find a project’s payback period?
Accumulated cash inflows or the remaining unrecovered investment balance for each period.
How is a fractional payback period calculated?
Add the full years before recovery to the unrecovered amount divided by the recovery-year inflow.
What assumption supports a fractional-year payback calculation?
Cash inflows are earned evenly over the recovery year.
What does the basic payback method ignore after the payback point?
Cash flows received after the initial investment has been recovered.

Quiz questions

  1. How does the basic payback method treat cash inflows received in different years?Answer: It adds them without adjusting for when they are received.
  2. What determines the maximum acceptable payback period under the payback method?Answer: A cutoff chosen by the company.
  3. Why can the basic payback method overlook important project returns?Answer: It stops counting cash flows once the investment is recovered.
  4. How does the basic payback method account for uncertainty in forecast cash flows?Answer: It makes no adjustment for differences in risk.
  5. What does a shorter payback period generally indicate, in the limited liquidity sense?Answer: The invested funds are recovered more quickly.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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