Payback Period (ACCA Online)

When a company has enough funds, it always uses its spare money to earn more money. Actually, there are two ways to earn money by spare money, one is loaning money to others and earning interest, the other is earning high payback by investing.

We pay more attention to the later in this article about ACCA. We will introduce you a method to assess investment appraisal for small businesses: Payback Period.

In some small businesses, the proprietors do not spend too much time and energy in creating an analysis of net present value, but use Payback period to evaluate whether a project should be carried out. This method also takes the risk into account. It means that the longer the payback period is, the higher the risk of the project is and the shorter the payback period is, the lower the risk is.
Payback period means how long does the company recovers its initial investment.  For example, when the payback period is 3 years, it means that the enterprise will take 3 years to recover its initial investment if it carries out this project.

Then let me introduce you how to calculate the payback period by 2 cases.
Case One:

LALA Company needs to invest in a project. It is expected to gain 100yuan in cash flow annually. However, if the enterprise wants to get these cash flows, it needs to invest 200yuan in this project. The company invested 200yuan in the project in the beginning and it recovered its initial investment in the second year. The company breaks even in the second year. Seeing that the company can obtain 200yuan after 2 years, the payback period for this project is 2years. So after 2 years, this project begins to gain profit.

 

Case Two:

SASA Company needs to invest in a project. It is expected to gain 100yuan in future cash flow in the first year, 300yuan in the second year and 500yuan in the third year. And the enterprise needs to invest 500yuan in this project in the beginning.

The calculation of the payback period in this project is a little complicated, we will explain it by a form.

It means that the enterprise has gained profit in the third year, but when did it recover its initial investment?

The answer is that the enterprise recovered its initial investment between the second year and the third year. We can calculate the specific payback period. The company has not recovered its initial investment in the second year and it gained -100yuan in the second year. It gained 500yuan cash flow in the third year. So we can get the formula: -100/500=0.2. It means that the company can recover its initial investment after 2years.

After calculation, let us check whether this method is good or bad.

Actually, this method is simple, we can calculate the formula by using excel form. We can get the answer quickly in this method. It is easy to understand.
But there is a disadvantage by using this method:

  • It doesn’t consider the future cash flow. Enterprises can not predict how many cash will flow into the enterprise.

The examiner in ACCA Examination will ask you to master the specific evaluation. If you are interested in this, you can learn it in our network class ACCA F9.