Q. Define and explain the procedure to calculate the payback period. Also state its significance.
Simple Payback Period (SPP) shows as a first approximation, the time (number of years) required to recover the initial investment (First Cost),considering only the net annual saving the simple payback period is normally calculated as follows :
Example :
Simple payback period = First cost / Yearly benefits – Yearly costs
Simple payback period for a continuous Deodorizer that costs ₹60 lakhs to purchase and install ₹1.5 lakhs per year on an average to operate and maintain and is expected to save ₹20 lakhs by reducing steam consumption (as compared to batch deodorizers), may be calculated as follows :
According to the payback criterion, the shorter the payback period, the more desirable the project. Simple payback period = 60 / 20 – 1.5= 3 years, 3 months
Advantages of Pay-Back Period
- It is simple, both in concept and application. Obviously, a shorter payback generally indicates a more attractive investment. It does not use tedious calculations.
- It favours projects, which generate substantial cash inflows in earlier years, and discriminates against projects, which bring substantial cash inflows in later years but not in earlier years.
Limitations of Pay-Back Period
- It fails to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting. This violates the most basic principle of financial analysis, which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding/discounting.
- It ignores cash flows beyond the payback period. This leads to discrimination against projects that generate substantial cash inflows in later years.
To illustrate, consider the cash flows of two projects, A and B :
The payback criterion prefers A which has a payback period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantial cash inflows in years.
|
Investment |
₹(100,000) |
₹(100,000 |
|
Savings in year |
Cash |
Cash |
|
1 |
50,000 |
20,000 |
|
2 |
30,000 |
20,000 |
|
3 |
20,000 |
20,000 |
|
4 |
10,000 |
40,000 |
|
5 |
10,000 |
50,000 |
|
6 |
– |
60,000 |
Example on calculation of kW, kVA loads :
[A] Step 1 : To calculate saving for kW load :
(a) Calculation for old system :
There are so many fixtures in such a load and knowing consumption of each of such fixtures the load per day can be calculated as shown below :
(i) Load per day (in kW) = (Consumption per fixture) x ( Total number of fixtures ) x Working hours /1000
(ii) Load per month = [(i)i.e. load/day ] x [Working days per month]
(iii) For the month expenditure = (i) x rate of per unit (i.e. Rs/kW) … say (x).
(b) Now for the new (proposed) system, similar calculations are as follows.
Note : These calculations are similar method as in (a) …. say (y).
(c) To calculate cost saving per month :
= [Old system consumption per month (i.e. x)] – [Proposed system consumption per month (i.e. y)]
∴ Saving/month – X Saving per year = Saving / month x 12 – 12 ( x – y )
[B] Saving of volt ampere (VA) load :
Similar procedure i.e. old system and new (proposal system VA = W/power factor.
- Old system : Total kVA load for all fixtures = VA x Number of Fixtures/1000 = (x)VAX Number of fixtures / 1000 = 6 m )
- Proposed new system VA x Number of fixtures/1000 ….(y).
- Savings = x – y
Monthly demand charge’s saving = (x-y) x Monthly demand charges per kVA saving =(z)
Yearly demand charges savings – 12 x (z).
[C] Calculations for payback period in years :
(i) Calculate total investment for new system, (ii) Pay-back periods in years = Investment/Total savings.
Significance of payback period : Payback period is an evolution method used to determine the amount of time required for the cash flows from a project to payback the initial investment in the project.
Advantages of the system : Very simple several projects can be compared , take the project of shortest payback time.