Page 123 - DMGT409Basic Financial Management

Basic Financial Management

Notes Advantages Pay Back Period

The Merits of pay back period are,
1. It is very simple and easy to understand.

2. Cost involvement in calculating pay back period is very less as compared to sophisticated
methods.

Limitations of Pay Back Period

Pay back period method suffers from certain Limitations such as:

It ignores cash flows after pay back period.

1. It is not an appropriate method of measuring the profitability of an investment, as it does

not consider all cash inflows yielded by the investment.
2. It does not take into consideration time value of money.
3. There is no rationale basis for setting a minimum pay back period.
4. It is not consistent with the objective of maximizing shareholders’ wealth. Share value does
not depend on pay back periods of investment projects.

Note For calculating payback period we need cash flows after taxes (CFAT)

Calculation of Cash flows after taxes (CFAT):
Particulars Rs.
Sales revenue xxx
Less: Variable cost xxx
Contribution xxx
Less: Fixed cost xxx
Earning Before Depreciation and Taxes (EBDT) xxx
Less: Depreciation xxx
Earning Before Taxes (EBT) xxx
Less: Taxes xxx
Earnings After Tax (EAT) xxx
Add: Depreciation xxx
Cash Flows After Tax (CFAT) or xxx
Earnings After Taxes but Before Depreciation (EATBD)

Illustration 1: A project requires an initial investment of ` 1,20,000 and yields annual cash infl ow
of ` 12,000 for 12 years. Find the payback period.
Solution:

1,20,000/12,000 = 10 years.

In case of unequal annual cash inflows, cumulative cash inflows will be calculated and by

interpolation, the exact payback period can be found out.
Illustration 2: The project requires an initial investment of ` 20,000 and the annual cash infl ows
for 5 years is ` 6,000, ` 8,000, ` 5,000, ` 4,000 and ` 4,000 respectively. Find the payback period.

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