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410 Corporate Finance BRILLIANT’S

CAPITAL BUDGETING: PAY-BACK PERIOD METHOD
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Q.47. Discuss the characteristics and relative merits and demerits of pay-back period method.
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OR
Explain the pay-back period method of capital budgeting with illustrations.
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Pay-back Period Method no-~¡H$ nr[a`S> _oWS>

The Pay-Back (PB) is one of the most popu- no-~¡H$ nr[a`S> _oWS> BÝdoñQ>_|Q> àñVmd H$mo ñdrH¥$V
lar and widely recognized traditional meth- H$aZo H$s bmoH${à` nÕ{V h¡, Omo ì`mnH$ Ed§ naånamJV
ods of evaluating investment proposals. It is ê$n go Cn`moJ _| bmB© OmVr h¡Ÿ& BgHo$ AÝVJ©V CZ dfm]
defined as the number of years required to AWdm Cg g_`md{Y H$s JUZm H$s OmVr h¡, {Og_| _erZ
recover the original cost outlay invested in a
project. If the project generates constant an- H$s bmJV H$mo H$da {H$`m Om gH$Vm h¡Ÿ& `{X à{Vdf© H$m
nual cash inflows, the pay-back period can be H¡$e BZâcmo EH$ g_mZ h¡ Vmo no-~¡H$ nr[a`S> H$s JUZm,
computed by dividing cash outflow by the H¡$e AmCQ> âcmo H$mo dm{f©H$ H¡$e âcmo go {d^m{OV H$aHo$
annual cash flow. That is: H$s Om gH$Vr h¡Ÿ Omo Bg àH$ma h¡:

Initial Investment I
Payback Period = = 0
Annual Cash Inflow C
Suppose, a project cost ` 20,00,000 and CXmhaU Ho$ {bE, `{X EH$ àmoOoŠQ> H$s bmJV
yields annually a profit of ` 3,00,000 after de- ` 20,00,000 h¡ VWm 12.5% (ñWm`r {H$ñV nÕ{V
preciation 12.5% (Straight line method) but be- go) S>o{à{gEeZ bJmZo Ho$ níMmV², {H$ÝVw 50% Q>¡Šg Ho$
fore tax 50%. The first step would be to calcu- nyd© dm{f©H$ bm^ ` 3,00,000 h¡ Vmo g~go nhbo Bg
late the cash inflow from this project. The cash àmoOoŠQ> Ho$ H¡$e BZâcmo H$s JUZm H$s OmEJrŸ& H¡$e BZâcmo
inflow is ` 4,00,000 calculated as: ` 4,00,000 h¡ Omo Bg àH$ma H¡$ëHw$coQ> {H$`m J`m h¡:

Profit before tax ` 3,00,000
Less: tax 50% ` 1,50,000
Profit after tax ` 1,50,000
Add: depreciation written off (non-cash expense) ` 2,50,000
Annual Cash Flow ` 4,00,000

While calculating cash inflow, deprecia- H¡$e BZâcmo H$s JUZm H$aVo g_` Q>¡Šg Ho$ níMmV²
tion is added back to the profit after tax since bm^ _| S>o{à{gEeZ nwZ… Omo‹S> {X`m OmVm h¡ Š`m|{H$ S>o{à{gEeZ
it does not result in cash outflow. The cash go H¡$e AmCQ>âcmo Zht hmoVmŸ& Bg àH$ma, àmoOoŠQ> go
generated from a project therefore is equal to
CËnÞ H¡$e, Q>¡Šg níMmV² cm^ _| S>o{à{gEeZ Omo‹S>Zo na
profit after tax plus depreciation.
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