Traditional Methods

Pay Back Period (PBP) Method 

Payback, or payout, period is the length of time required to recover the first cost of an investment from the net cash inflow produced by that investment for an interest rate equal to zero. If is the first cost of the investment and if F, is the net cash flow in period t, then the payback period is that value of n that satisfies the following equation : If F, is constant for all t, then it is the ratio of the initial fixed investment over the annual cash flow (taken numerically and not algebraically). And, the Pay Back Period (PBP) can include fractions of years also. Thus, if the initial cash outlay was Rs. 2,00,000 and the net cash flow in each year was Rs. 48,000, then the PBP summation of F,'s  are made starting from the first year and fractions interpolated if necessary. Thus, if F,'s  were Rs. 25,000; Rs. 45,000; Rs. 65,000; Rs. 35,000; Rs. 40,000; Rs. 25,000 in six successive years, first to sixth, respectively, PBP is through the fifth year, since the first four years would pay back Rs. 1,70,000 and the first five years would pay back Rs. 2,10,000. Considering pro-rata, PBP would be four years plus three-fourth of the fifth year, i.e. 4-3/4 years. 

If the PBP calculated is less than a-pre-stipulated (maximum) acceptable period, the proposal is accepted; if not, rejected. If the desired PBP was 3 years the above proposal would have been rejected; if desired PBP was 5 years, the proposal would have been accepted. In that case, it matters nothing whether there was any cash flow on sixth year or any later year. This failure to consider the cash flows after the PBP is one main drawback of this method. Moreover, even if the above had been reordered in the sequence : Rs. 65,000; Rs. 45,000; Rs. 35,000; Rs. 25,000; and then followed by Rs. 40,000 and Rs. 25,000; the PBP would have stream of F,'s  compared to the former stream, since longer amounts are recovered in earlier years in this latter stream. This is yet another drawback of this method, viz. it does not take into account the magnitude or timing of the cash flows during the PBP; it considers only the recovery as a whole. Additionally, salvage value too is neglected in this method; but this statement can be considered as included in the previous statement that it mattered nothing if there was any cash inflow beyond the PBP.