# Payback period

Registered Posts: 130 ? ? ?
Not sure where to start on this question as cant find it in the osborne books. I need to know what assumptions need to be made for timing of cashflows when carrying out Payback and NPV investment appraisals?? any clues??

• Registered, Moderator Posts: 2,034
If you find a project pays back in 3.5 years, when does it pay back within year 4?

If it is a big toy shop when the net cash flow each month is 5% per month in Jan to October 25% in November and 25% in December then the point at which 0.5 of the cash flow has been received is at the end of month 10.

If the business has a strong summer bias then the 0.5 of cash flow in year 4 could be at the end of May (i.e. 5/12ths through the year)

So 3.5 years is all well and good as a piece of arithmetic, but doesn't mean anything more than "within 4 years"

In this skills test if you say 3.5 years "assuming that cash flows accrue evenly in year 4" you are showing your assumption.
between you and me it is practically useless, and I am yet to find an organisation that has a perfectly even cash flow throughout the year
Sandy
[email protected]
www.sandyhood.com
• Registered, Moderator Posts: 2,034
Amazingly, NPV makes a different assumption as far as the net cash flow each year is concerned!

If you are discounting your cash flows year by year, you use a single discount factor. So it is assumed that your cash flow for year 1 is all on the last day of the year, and for year 2 etc
Sandy
[email protected]
www.sandyhood.com
• Registered, Moderator Posts: 2,034
I've noticed a new development which appears to be most common in computer based exams some questions want you to state the payback period in years and months.
This precision is not useful, but in some respects we need to bite our lips and get on with answering the question as written.
So if you find that at the end of year 3 you still need £4,000 to payback a project, and the net cash flow in year 4 is £8,000 then the calculation is:
...............£4,000 required
3 years +
............... = 3 + 0.5 years.................... and 0.5 x 12 months per year = 3 years + 6 months
...............£8,000 earned in year 4

Answer 3 years and 6 months
Sandy
[email protected]
www.sandyhood.com