Questions:
How are payback periods used in capital budgeting?

We are considering investing in a facility with an initial outflow of 500,000. The project is expected to generate cash flows of 100,000 in the first year, with an annual growth rate of 7% for the next 5 years. Assuming a discount rate of 3%, how long will it take to recover the initial investment based on the payback period, considering the time value of money and the projected increase in cash flows?

Reference answers:
The payback period is the expected amount of time for an investment to generate returns that exceed its costs. A payback investment rule will normally define a timeframe that a payback period must meet. For example, a firm could decide to only invest in projects that will break even after four years.

The initial investment is 500,000. The cash flow in the first year is 100,000, with a 7% increase each year for the next 5 years. Using a 3% discount rate, here’s how to calculate the payback period:

*Year 1 cash flow = 100,000, discounted to 97,087.38
*Year 2 cash flow = 107,000, discounted to 100,710.68
*Year 3 cash flow = 114,490, discounted to 104,924.45
*Year 4 cash flow = 122,104.3, discounted to 108,870.16
*Year 5 cash flow = 130,050.6, discounted to 112,577.92

The cumulative discounted cash flow after each year is:

*End of Year 1: 97,087.38
*End of Year 2: 197,798.06
*End of Year 3: 302,722.51
*End of Year 4: 411,592.67
*End of Year 5: 524,170.59

By the end of year 5, the cumulative cash flow is forecasted to exceed 500,000, and the initial investment should be recouped.