Cashflow Payback Period Method: Two Kinds of Cash Flows
Cashflow payback period method is a kind of method that is used to evaluate projects through the movement of cash into the business out of the project that is being financed by the company. It considers the time required by management to recover the original investment.
When the cash flows of a project are of the same amount each period, this is how to calculate cashflow payback period:
Payback Period = Original investment divided by annual cash flows
Using the data for Henry Manufacturing:
Investment on the plant equipment $1,000,000
Annual Cash flows from the project $150,000
The payback period or the number of years that Henry may be able to recover its investment is:
Payback period = $1,000,000 divided by $150,000
Payback period = 6.67 years
If cash flows are not the same amount each period, payback is calculated by adding the annual cash flows until the original investment is recovered.
Going back to Henry, for example, cash flows are different each year, like below:
Period cash flows:
1st year $150,000
2nd year $100,000
3rd year $200,000
4th year $150,000
5rh year $250,000
6th year $150,000
In this case, Henry Manufacturing will be able to recover its investment of $1,000,000 in 6 years.
As a guide for evaluating project proposals, companies may set a maximum payback period for all projects and reject projects that exceed the maximum payback period allowed.