Fianancial Payback Period

Question: Discuss about the Report for Fianancial Payback Period. Answer: (A) Year Cash Flow NPV @ 10% 0 - 30,00,000 - 30,00,000 1 7,00,000 6,36,364 2 7,00,000 5,78,512 3 7,00,000 5,25,920 4 7,00,000 4,78,109 5 - 13,00,000 - 8,07,198 6 7,00,000 3,95,132 7 7,00,000 3,59,211 8 7,00,000 3,26,555 9 7,00,000 2,96,868 10 9,00,000 3,46,989 1,36,463 It is clear from the above calculation that NPV is positive. Therefore, RWE will create additional value of $ 136,463 over and above the required rate of return of 10%. RWE should take this project based on NPV method. However, it is better if we consider other factors like payback before deciding about the project. (C) Year Cash Flow NPV @ 10% Cumulative Cash Flow Cumulative Discounted Cash Flow 0 - 30,00,000 - 30,00,000 - 30,00,000 - 30,00,000 1 7,00,000 6,36,364 - 23,00,000 - 23,63,636 2 7,00,000 5,78,512 - 16,00,000 - 17,85,124 3 7,00,000 5,25,920 - 9,00,000 - 12,59,204 4 7,00,000 4,78,109 - 2,00,000 - 7,81,094 5 - 13,00,000 - 8,07,198 - 15,00,000 - 15,88,292 6 7,00,000 3,95,132 - 8,00,000 - 11,93,160 7 7,00,000 3,59,211 - 1,00,000 - 8,33,949 8 7,00,000 3,26,555 6,00,000 - 5,07,394 9 7,00,000 2,96,868 13,00,000 - 2,10,526 10 9,00,000 3,46,989 22,00,000 1,36,463 1,36,463 Payback period = 7 + (100000 / 700000) = 7 + 0.14 = 7.14 Discounted Payback = 9 + (210526 / 346989) = 9 + 0.61 = 9.61 Payback period tell us how quickly we can recover our investment in a project. We are talking about just investment amount, not of profit. If the investment is recovered in the initial years of the project. That project is said to be less risky. But if the investment is recovered in last stages of the project, project will be considered very risky. A business should try to take very cautious decision in these kind of projects. In the given case, payback period (without discounting) is 7.14 years. Since, this is at the later stage of the project, project will be considered risky. Discounted payback period is 9.61 years. Out of the total period of 10 years, RWE is able to recover its investment in year 10. Therefore, this project is very risky. Discounted payback period is considered to be more relevant than non-discounted payback period. Reason being discounted payback takes into account the time value of money which is ignored by simple non-discounted payback method. Depending upon the discounted payback method, this project will be called very risky. Management needs to take decision very carefully in this case. As if the projections moves slightly on lower side, this project will run into losses. Looking at the data, it appears that even a 5% variation in projection will lead project into losses.